Yoram Keinan Taxation of Financial Instruments

Derivatives

Transcript

1. Introduction to Derivatives
2. Introduction to Financial Products Page 2 What Are “Derivatives”? ► A derivative instrument is a financial instrument whose value is derived from one or more underlying assets, market securities or indices. The derivative contract specifies conditions – in particular, dates and the resulting values of the underlying variables – under which payments, including the ultimate settlement, are to be made between the parties.
3. Introduction to Financial Products Page 3 Examples of Derivatives ► Forwards ► Futures ► Options ► Notional Principal Contracts ► Swaps ► Caps ► Collars ► Floors
4. Introduction to Financial Products Page 4 Who Uses Derivatives? ► Dealers ► Traders ► Investors ► Hedgers ► Speculators
5. Introduction to Financial Products Page 5 Examples of Derivatives Used as Hedges Forward contract to buy euros Company plans borrowing in near future and wants to hedge against interest rate increase Company enters into purchase agreement denominated in euros and wants to hedge against possible decline in value of dollar against the euro Manufacturer uses natural gas in production and wants to hedge against increased fuel costs, but retain benefit if prices drop Futures contract to sell Treasury bonds Option to buy natural gas
6. Introduction to Financial Products Page 6 Long and Short ► Having a “long” position in property means you own it, have a right or contract to buy it for a fixed price, or otherwise profit from the appreciation in the property and/or suffer from a decline in its value. ► Having a “short” position means you have a contract or obligation to deliver or sell the property for a fixed price, or otherwise profit from a decline in the value of the property and/or suffer from an increase in its value.
7. Forward and Futures Contracts
8. Introduction to Financial Products Page 8 What is a Forward Contract? ► Contract where seller (short position) agrees to deliver to the buyer (long position): ► Specified property ► At specified price or rate (contract price or rate) ► On a specified future date (forward date) Seller Buyer Forward Price Property $ $0$ $ For Delivery in Future
9. Introduction to Financial Products Page 9 What is a Forward Contract (Cont.)? ► Other characteristics ► Not exchange-traded ► Non-standardized terms that can be tailored to client ► Price and quantity generally fixed, but also can be variable determined by a formula ► Holder generally makes no initial payment because contract price/rate is set so that contract’s initial value = $0. But a forward contract can also be “prepaid,” which means that one party pays cash up front and receives specified property on a specified future date. ► Can be “cash settled” for the difference between the specified price and the value of the property.
10. Introduction to Financial Products Page 10 Forward Contract – Examples ► On January 15, 2015, A and B enter into a contract under which A agrees to sell to B (and B commits to purchase) 100,000 barrels of a specified grade of crude oil on July 15, 2015 at a price of $95 per barrel, to be paid on the same date the oil is delivered. ► Prepaid forward contract: Same as above, except that B pays A $9.4 million on January 15, 2015 in exchange for B’s commitment to deliver 100,000 barrels of oil on July 15, 2015. ► Cash settlement: The spot price of oil on July 15, 2015 is $90 per barrel. On the first contract, the parties settle by B making a cash payment of $500,000 to A. No oil is actually delivered (at least not by A).
11. Introduction to Financial Products Page 11 What is a Futures Contract? ► Similar to forward contract, in that it provides for: ► Receipt or delivery of specified amount of property ► At specified price or rate ► On specified future date ► Distinguishing characteristics ► Exchange traded ► Standardized terms (notional amount, settlement date, etc.) ► Requires deposit in margin account to secure performance ► Any decline in value must be deposited daily and any increase in value can be withdrawn daily (“variation margin”). ► Usually terminated by offset rather than delivery of property ► For instance, to close out contract to sell (short position), enter corresponding contract to buy (long position)
12. Introduction to Financial Products Page 12 Taxation of Forwards and Futures ► Section 1001 – If no special recognition rule applies, normal gain/loss realization rules apply (wait-and-see). ► Common law – If property is acquired pursuant to a forward contract, the property is just treated as having been acquired for the forward price. Gain or loss is not recognized at the time of purchase. Similarly, the seller does not separately recognize gain or loss on the contract, only on the property sold.
13. Introduction to Financial Products Page 13 Taxation of Forwards and Futures ► Section 1256 – Regulated futures and certain other contracts are subject to mark-to-market accounting, regardless of the identity of the taxpayer, with gains and losses treated as capital ► Section 475 – Dealers in securities and electing traders and dealers and traders in commodities are subject to mark-to-market accounting for all derivatives (with limited exceptions), and all gains and losses are ordinary ► Mark-to-market taxation means every open position is deemed sold or otherwise terminated for its fair market value on the last day of the taxable year (and effectively deemed repurchased or newly entered into for that price).
14. Introduction to Financial Products Page 14 Taxation of Forwards and Futures – Tax Rules Based on the Use of the Product ► Business hedges ► Includes certain transactions designed to manage business risks ► Gain/loss is ordinary in nature, and timing is subject to matching rules (Treas. Reg. §§1.446-4 and 1.1221-2) ► Straddles ► Definition – Taxpayer enters into offsetting positions, such as long and short positions on same stock ► Section 1092 defers loss recognition if there is unrealized gain on an offsetting position ► More on both these topics in the next class
15. Options
16. Introduction to Financial Products Page 16 Option Basics ► Option – Contract that grants right, but not obligation, to buy or sell property at a fixed price within a specified time period or on a specified date ► Written on stocks, bonds, commodities, and currencies ► Employee stock options are special case (not discussed) ► Call option – Right to purchase property ► Put option – Right to sell property Option writer (seller) Option holder (buyer) Premium Property $ $0$ $
17. Introduction to Financial Products Page 17 Option Basics (cont.) ► Writer (or grantor) – Seller of option ► Holder – Purchaser of option ► Premium – Price paid for option (usually a lump sum up front) ► Expiration date – Last day option can be exercised ► Strike price – Stipulated purchase price (call option) or sales price (put option) ► Lapse – Holder fails to exercise option on or before expiration date ► Listed option – Standardized option (notional amount, expiration date, etc.) traded on an exchange
18. Introduction to Financial Products Page 18 Call Options ► Call option: a contract that allows the holder to buy a specified quantity of stock (or other property) from the option writer at a fixed price for a given period. ► Example: a purchaser of a call option pays $10 to the writer of the option for the right to purchase one share of IBM stock at $100 from the writer on (or before) June 15, 2015. ► Thus, if the market value of IBM stock were to be below the price specified in the option contract, the holder normally would not exercise the option and would allow it to lapse. On the other hand, if the market value of the underlying stock were to rise above the price specified in the option contract, the holder probably would exercise the option on its maturity date. ► Generally no benefit from exercising an option early because price could change later.
19. Introduction to Financial Products Page 19 Put Options ► A contract that allows the holder to sell a specified quantity of stock to the writer of the contract at a fixed price on a given date or during a given period. ► Thus, if the market value of the stock that is the subject of the option were to be above the price specified in the option contract, the holder of the put normally would not exercise the option and would allow it to lapse. On the other hand, if the market value of the underlying stock were to fall below the price specified in the option contract, the holder most likely would exercise the put.
20. Introduction to Financial Products Page 20 More Option Terminology ► A call option is “in the money” if the property is worth more than the strike price. “At the money” means strike price equals value. A call is “out of the money” if the property value is less than the strike price. ► These tests can be imposed at any time. ► Corresponding concepts apply for put options. ► An option’s intrinsic value is its value if it were exercised immediately. An option has intrinsic value only to the extent it is in the money. ► The remaining value of an option is called its time value. The time value of an option on its maturity date is zero.
21. Introduction to Financial Products Page 21 Tax Treatment – Options Not Marked to Market ► For options that are not marked to market (see below): ► No taxable event upon entering into the option, ► If option is cash-settled, gain or loss on the option is the difference between (or sum of) the amount of the option premium and the cash settlement amount. ► If the option is physically settled, price paid for property is the sum of (call option) or difference between (put option) the option premium and the exercise price. ► § 1234(b): in the case of the grantor, any gain or loss is short-term, even if the option was for more than 1 year.
22. Introduction to Financial Products Page 22 Option Tax Treatment – Example ► T owns 100 shares of X Corp with a basis of $10 per share ($1,000 total basis). T buys an option to sell 100 shares of X Corp for $50 per share on June 15, 2015. T pays $700 for this put option. ► On the expiration date, X Corp is trading for $45 per share. ► If T cash settles the option, T receives $5 per share, or $500. So T has a loss of $200 on the option. ► If T physically settles the option with the 100 shares , T is treated as having sold the shares for $4,300 ($5,000 – $700), so has a gain of $3,300.
23. Introduction to Financial Products Page 23 Options That Are Marked to Market ► Section 1256 contracts are marked to market. ► An option is a section 1256 contract only if ► It is listed on a qualified board or exchange, and is either ► A dealer equity option or ► A nonequity option ► For this purpose, an option on a broad-based stock index such as the S&P 500 is treated as a nonequity option. ► Under section 475, a “dealer in securities” or electing “trader” must generally mark to market all of its securities (including options and other derivatives). ► There is an exception for identified positions that are hedges of other positions that are not marked to market
24. Introduction to Financial Products Page 24 Source Rules for Forward, Futures and Options ► Gain on the disposition of an option, forward or futures contract generally is sourced according to the residence of the contract holder receiving the gain. ► Thus, capital gain recognized by a foreign holder would be foreign-source gain that would not be subject to U.S. tax, unless the foreign holder is engaged in a U.S. trade or business with which the gain is connected. ► These rules would also apply if the derivative is used for hedging purposes. ► Section 865(j)(2) authorizes Treasury to promulgate regulations governing the source of gain from dispositions of forward contracts, futures, options, and other financial products. These regulations have not been promulgated to date.
25. Notional Principal Contracts
26. Introduction to Financial Products Page 26 Notional Principal Contracts (NPCs) ► Definition – Financial instrument that provides for: ► Payments between contracting parties ► At specified intervals ► Calculated by reference to a specified index ► Upon a notional principal amount ► In exchange for specified consideration or promise to pay similar amounts (Reg. §1.446-3(c)(1)) ► Proposed regulations in 2011 would broaden the definition of specified index to include certain non-financial information, such as weather-related data (degree days, etc.).
27. Introduction to Financial Products Page 27 NPCs (Cont.) ► Notional principal contracts include interest rate swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, currency swaps, and similar agreements. ► Section 1256 contracts, debt instruments, options and forward contracts do not constitute notional principal contracts. ► Function – Most often used to hedge against risks of adverse price or interest rate fluctuations in the future. Counterparties are usually banks or dealers who can offset or absorb the risk.
28. Introduction to Financial Products Page 28 Interest Rate Swaps ► Taxpayer (T) and dealer (D) agree that, for a term of 5 years, ► T will make semiannual payments to D based on fixed rate (say 5%) times a notional principal amount (say $100 million) ► D makes semiannual payments to T based on floating interest rate (say 6-month LIBOR*) times the same notional principal amount. ► In practice, payments between T and D are always netted. ► *LIBOR stands for London Interbank Offered Rate. LIBORs are published daily for various currencies and various maturities up to one year.
29. Introduction to Financial Products Page 29 Interest Rate Swap Used as a Debt Hedge ► T might enter into this swap to synthetically convert a 5- year floating-rate borrowing of $100 million into a fixed rate borrowing. ► If the interest rate on the debt is 6-month LIBOR plus 2 percent, payable semiannually on the same dates as the swap payment dates, and ending on the same date as the maturity date of the debt, then the combined cash flows on the debt and the swap are that T pays 7 percent, regardless of the value of LIBOR.
30. Introduction to Financial Products Page 30 Interest Rate Cap ► Taxpayer (T) and dealer (D) agree that, for a term of 5 years, ► D will make semiannual payments to D based on the excess of LIBOR over a fixed rate (say 8%) times a notional principal amount (say $100 million). ► T makes an up-front payment of $7 million for this cap. ► If T is the obligor on a 5-year $100 million debt with interest at a rate of LIBOR plus 2 percent, then this interest rate cap effectively limits T’s interest expense to 10 percent a year. ► Economically, a cap is like a series of options rolled into a single contract.
31. Introduction to Financial Products Page 31 Taxation of NPCs ► The regulations group all payments under an NPC into three categories: (i) periodic payments; (ii) non-periodic payments; and (iii) termination payments. ► All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment and a non-periodic payment for the taxable year to which such portions relate. ► A non-periodic payment must be amortized and recognized over the contract term in a manner that reflects the economic substance of the contract. ► A termination payment is recognized by the original party to the contract as income or deduction when the contract is extinguished, assigned, or exchanged.
32. Introduction to Financial Products Page 32 Source of Income from NPCs ► Periodic payments are sourced according to the residence of the recipient. ► Thus, periodic payments received by a foreign holder are foreign-source income not subject to U.S. withholding tax, assuming the foreign holder is not engaged in a U.S. trade or business. ► Under section 871(m), certain payments to a foreign holder on certain NPCs that are linked to U.S. equities are considered dividend equivalents and are subject to withholding as if they were dividends.
33. Legislative Proposal
34. Introduction to Financial Products Page 34 Tax Reform Proposals Affecting Derivatives ► In January 2013, then House Ways and Means Committee Chairman Dave Camp released a Discussion Draft that would change the taxation of financial products in various ways. In February 2014, Camp released a discussion draft of a much broader tax reform bill. ► Of greatest impact among the Camp financial product proposals, all derivatives would be marked to market and all gains and losses would be treated as ordinary. ► Exception for derivatives used as hedges, and special rules for straddles ► The Obama Administration’s FY 2016 Budget contained the same basic proposal. ► Not enacted as part of the TCJA in 2017.