Taxation of Financial Instruments: Is the Debt/Equity Distinction Relevant? Presentation to the President’s Advisory Panel on Federal Tax Reform Robert McDonald Erwin P. Nemmers Distinguished Professor of Finance Kellogg School of Management Northwestern University 11/14/2018

Overview Traditional distinctions among kinds of financial income The role of dealers Prevalence and growth of derivatives Examples Complexity of rules governing taxation of financial transactions As David Weisbach pointed out, there are numerous issues; I am touching on one particular issue. 11/14/2018

Types of Financial Income The tax code distinguishes between debt and equity and between interest, dividends, and capital gains It is well-known that in certain cases the debt-equity distinction is problematic, for example junk bonds and convertible bonds have both debt and equity characteristics Distinctions between forms of financial income are not economically meaningful All represent returns to a financial investment 11/14/2018

Derivatives Blur the Distinctions In modern financial markets, derivatives can be constructed that have characteristics of both debt and equity. Derivatives are financial claims that have a payoff determined by the price of some other asset Futures, options, and swaps are examples of derivatives (as is automobile insurance!) The technology for creating new financial claims is well understood and creation of new claims is common 11/14/2018

What do Dealers Do? Securities dealers make markets in financial instruments, accommodating customer demand to buy and sell financial instruments Dealers buy and sell stocks, forward contracts, options, and customized financial claims A forward contract is an agreement to buy or sell in the future at a price fixed today Call options and put options are like forward contracts --- the transaction price is fixed today --- except that the customer only buys the asset (call) or sells (put) if they profit by doing so. This activity leaves dealers with exposure to price risk Dealers generally hedge this resulting exposure, i.e., they acquire an offsetting position that makes money if the position due to their customers loses money. 11/14/2018

The Role of Dealers: Example A customer owning shares worth $100 wants to sell the shares 5 years from today for a guaranteed price of $125 (this is a forward sales contract) The dealer agrees to buy the shares in 5 years for $125. The dealer has the risk that the share price in 5 years will be less than $125 To offset the risk stemming from this agreement, the dealer needs a position that will make money if the stock price declines. Thus, the dealer short-sells: borrows shares from a third party and sells them, investing the sale proceeds in bonds. If the share price falls, the dealer can buy replacement shares at a low price, making money on the short sale. The dealer has a forward purchase contract and an economically equivalent offsetting position that is short stock and long bonds. 11/14/2018

The Role of Dealers, cont. With the help of the dealer, the customer has converted a share position into the economic equivalent of a bond (a certain return in 5 years) The dealer bears no share price risk This particular transaction would be deemed a sale under the constructive sale rules, but there are close variants in which the customer retains some risk and can defer tax 11/14/2018

The Revolution in Financial Technology Black, Scholes, and Merton showed in the early 1970s how to price and hedge options and other derivatives more complicated than forward contracts; their analysis created financial engineering Dealers routinely use this technology to price and hedge claims such as options Dealers trade stocks and bonds to hedge options and other derivatives Dealers can also create synthetic stocks and bonds by trading derivatives Dealers mark-to-market, and all dealer income is ordinary, so distinctions between kinds of income are often not preserved when dealers are intermediaries Virtually all derivatives are equivalent to a long position in some asset and a short position in some other asset. For example, a call option has a synthetic equivalent of borrowing to buy stock 11/14/2018

Effects of the New Technology With dealers able to create hybrid claims --- or assist firms in designing them --- traditional distinctions between debt and equity and types of financial income are harder to identify and support The market for derivatives has grown tremendously in the last 30 years. 11/14/2018

Growth in Derivatives: Swaps and Exchange-Traded Options Sources: Chicago Board Options Exchange and ISDA 11/14/2018

The Traditional View of Debt and Equity Equity has no promised maturity payment and is risky Debt has a promised maturity payment and is relatively safe It is easy to design “hybrid” instruments that have characteristics of both debt and equity. 11/14/2018

What are These? “DECS” (Debt Exchangeable for Common Stock) is here used as generic shorthand for a hybrid debt-equity claim Both payoffs have characteristics of debt and equity Depending on circumstances, characteristics, or documentation, claims like these can resemble debt or equity for tax purposes. Existing positions can be modified to resemble these diagrams by adding options and forward contracts 11/14/2018

Example: Individual Capital Gains Deferral Suppose a wealthy investor has $1 billion dollars in appreciated stock. The investor collars the position: in 5 years the investor has the right to sell the stock to a dealer for $1 billion and is required to sell to the dealer for $1.75 billion if it is worth more than that. The investor pays nothing for this position. The investor is protected against losses and gives up gains above a certain level Capital gains on the position are deferred for at least 3 to 5 years At the outset, such a position might be economically equivalent to 75% debt and 25% equity, yet it is completely untaxed (except for dividends paid on the stock) for 3-5 years The implicit interest income on the position is taxed as capital gain, if at all 11/14/2018

Example: Corporate Uses of DECS-like Structures In one well-known transaction, Times Mirror (which owned an appreciated position in Netscape stock) sold a DECS-like note with a principal payment linked to the price of Netscape. Times Mirror effectively deferred tax on $75 million of capital gains. The net result was like a collar. In a common transaction, firms issue a DECS-like security (also called “Feline PRIDES”) in the form of a bond coupled with a forward sales contract. The economic result is a deferred issue of equity, but a portion of payments on the security are deductible as interest. 11/14/2018

A Multitude of Rules for Investors Rules have been added ex post to stop egregious abuses. Examples include: Income on a position that looks like a bond should be taxed as interest Bonds that do not pay explicit interest should be taxed as if they do pay interest. A completely hedged position is deemed to have been sold Hedging stops the capital gains holding period But there are special exceptions for exchange-traded options There are special rules for the taxation of futures contracts The tax law tries to draw distinctions that are not economically supportable. Sophisticated taxpayers can use tax rules and financial instruments to obtain substantial tax benefits. 11/14/2018