Towards Equal Tax Treatment of Economically Equivalent Financial Instruments: Proposals for Taxing Prepaid Forward Contracts, Equity Swaps, and Certain Contingent Debt Instruments

Abstract

In recent years, many commentators have debated the merits of various proposals regarding the taxation of financial derivatives. The Internal Revenue Service (the "Service") has, in the case of certain derivatives, attempted to settle that debate by issuing regulations that address the taxation of notional principal contracts and contingent debt instruments. The debate, however, continues, mainly because many financial instruments are economically equivalent to one another and yet give rise to different tax results. Rather than proposing changes in the tax treatment of specific instruments, commentators now call for the complete overhaul of all of the rules governing the taxation of all financial instruments. While many of those proposals certainly have merit, it seems as though the Congress is not likely to completely overhaul the Internal Revenue Code (the "Code") any time soon.
A good deal of the debate concerning the taxation of financial derivatives has centered on the corporations that issue these derivatives (the "issuers"). In the author's opinion, many of the problems and abuses cited by those commentators should be solved not by focusing on the issuer, but by focusing on the investor who purchases these derivatives. That conclusion stems from the following four facts: First, issuers develop complex financial instruments such as contingent debt instruments in order to accommodate the demands of investors.5 Second, issuers of complex financial instruments often enter into hedging transactions that leave them in the same position in which they would have been, with respect to both economic result and tax treatment, had they issued traditional fixed or floating rate debt instruments. Third, investors will be taxed differently depending on the type of derivative that they purchase. Fourth, so long as issuers can save money by issuing financial derivatives such as contingent debt instruments, they will continue to do so. Thus, issuers usually design derivatives to save money by accommodating a particular investor profile. In light of that fact, the government should focus its reform efforts on investors.