Taxation of New Financial Instruments - United Nationsunpan1.un.org/intradoc/groups/public/documents/un/unpan...Taxation of New Financial Instruments* * The present paper was prepared

ST/SG/AC.8/2001/CRP.10______________________________________________________________________________________________________________________________________________________

17 August 2001

English___________________________________________________________________________

Ad Hoc Group of Experts on InternationalCooperation in Tax MattersTenth meetingGeneva, 10 - 14 September 2001

Taxation of New Financial Instruments*

* The present paper was prepared by Mr. Victor Thuronyi, Senior Counsel (Taxation), International Monetary Fund. The views and opinions expressed therein are those of the author

2

1 Prepared by Victor Thuronyi, Senior Counsel (Taxation), International Monetary Fund. The views expressed herein are the author=s personal views. The paper relies on the sources cited, and has also benefited from the helpful comments of: David Rosenbloom, Emil Sunley, Howell Zee, and Geerten Michielse.

2 For example, New Zealand and the United States.

3 For a discussion of the policy issues, see Tim Edgar, The Income Tax Treatment of Financial Instruments: Theory and Practice (2000); OECD, Innovative Financial Transactions: Tax Policy Implications (Dec. 17, 1996); Alvin C. Warren, Jr., Financial Contract Innovation and Income Tax Policy, 107 Harv. L. Rev. 460 (1993).

4 Any grouping of countries is arbitrary and not fully satisfactory. To indicate approximately those countries with more complex financial and taxation systems, this note refers to OECD

and do not necessarily represent those of the United Nations.

Taxation of New Financial Instruments1

I. Introduction

1. New financial instruments (NFIs) have been a concern for tax officials for some time because they pose difficulties for the application of tax rules based on traditional categories. For each type of income under a financial instrument, there are broadly three issues: (1) the type or character of the income (ordinary income, capital gain, interest, dividends, etc.), (2) the time when the income or deduction is taken into account, and (3) whether the income is domestic or foreign source and is subject to withholding at source. Financial innovation upsets existing categories because it is possible to convert one type of income or instrument into another or into a combination of different types which are often treated differently for tax purposes. Financial instrument A may be equal to B + C, but where the tax treatment of A is not the same as the tax treatment of the combined instruments B and C, given differences in character of income, timing, and source, tax planning opportunities can arise and the income tax ends up being applied inconsistently to economically equivalent positions.

2. While a few countries with very complex tax systems and economies have partially developed new taxation schemes to deal with NFIs,2 no country has fully grappled with the issues posed by NFIs. Neither has the system of tax treaties been revised to deal with NFIs in a satisfactory manner. Tax theorists have debated to what extent existing systems would have to be reformed if NFIs are to be dealt with comprehensively.3 While, as noted, some countries have already enacted complex new schemes for NFIs, most countries, particularly those not OECD4 members, have not

3

member countries.

5 See, e.g., Tim Edgar, supra note 3; OECD, Taxation of New Financial Instruments (1994); C. Plambeck, H.D. Rosenbloom, and D. Ring, General Report, 85b Cahiers de droit fiscal international (1995); L. Lokken, Taxation of derivatives and new financial instruments, in Report

included many provisions dealing with NFIs in their tax laws. The paucity of legislation on this subject in most developing and transition countries is partly due to the fact that solutions have not been identified. The thinking may be that these countries cannot expect to solve in their taxation systems problems that countries with more sophisticated systems have not been able to deal with and, in addition, that the simpler nature of their economies makes it less important to deal with NFIs for the time being.

3. This paper argues that there are indeed measures that developing and transition countries can take concerning NFIs in the near term, but that these measures are limited. The focus of this paper is on what these countries can do within the constraints of existing tax treaties over a period of the next few years. The paper focuses on the income tax, since this raises the most difficult issues of general concern. VAT issues are touched on, partly by way of reminder that issues do arise for taxes other than the income tax. Other taxes (for example, assets taxes, stamp duties and other transfer taxes) are not dealt with here since the issues raised are more specific to particular jurisdictions, but countries with such taxes should review them to the extent that NFIs pose problems. The paper is intended to be read in conjunction with other papers being made available to this meeting, as well as material cited in the footnotes.

4. Since the focus of this paper is on the near term, systematic possible reforms of the taxation of income from capital, including the question of division of revenue between source and residence countries under the international tax regime, are not explored. Neither does the paper consider general questions of policy regarding the taxation of capital income by developing and transition countries. The general policy concerning, for example, imposition of a withholding tax on interest paid abroad is taken as a given. The focus of the paper is on the treatment of NFIs given the particular country=s general policy for taxing interest and other forms of income paid abroad.

5. While the paper speaks in general terms, it is not intended to suggest that its conclusions should be applied without suitable modification for the circumstances of particular countries. Since countries differ substantially in the tax and legal systems and in their economies, no approach can be applied or recommended uniformly.

VI. What is Meant by NFIs

7. This paper will not discuss NFIs in detail since this has been done elsewhere.5 For

4

of the Ad Hoc Group of Experts on International Cooperation in Tax Matters on the Work of its Eighth Meeting (UN 1998).

6 See John Neighbour, Innovative Financial Instruments Challenge the Global Tax System, Tax Notes Int=l 931 (1997).

7 See Edgar, supra note 3.

purposes of this paper, NFI means any financial instrument or arrangement that differs from a simple debt or equity instrument. This would include:

• Derivatives (including options, forwards, and futures);• Instruments having characteristics of both debt and equity (examples include preferred stock, convertible debt or equity, and debt instruments with unusual features, such as zero-coupon bonds or equity kickers);• Other arrangements (such as securities lending and repurchase agreements (repos)).6

4. Such a broad concept of NFI is appropriate because tax rules must be prepared to cover whatever financial instruments the market can devise. At the same time, it should be understood that the concept of NFI is by its nature not a precise one. From a policy point of view, NFI should include any instrument or arrangement that does not neatly fit into existing categories of debt or equity. Thus, an instrument with OID can be viewed as an NFI even though it is a pure debt instrument, given that it includes interest that is not paid until maturity and that the discount may under some countries= legal concepts be characterized as a capital gain rather than as interest. More generally, financial innovation can take the form of any number of transactions that tax or financial planners can devise, which will vary according to the particular country=s legal system and tax laws.

5. Indeed, financial innovation calls into question the whole structure of taxation for financial instruments, even traditional ones.7 Thus, the fact that this paper focuses on NFIs should not be construed as implying that tax rules for NFIs should be designed in isolation from those applicable to traditional instruments.

6. The inherent difficulty in defining NFIs should particularly be kept in mind if an attempt is made to define new financial instruments, or specific categories thereof, such as derivatives, in tax legislation. Given the malleability of NFIs, great care should be taken with any statutory definition lest it be imprecise. A detailed definition, unless very carefully structured, can fall prey to tax planners who will parse the definition precisely and devise arrangements that fall outside the scope of the definition if it is in their interest to do so.

5

8 There will be exceptions, depending on the peculiarities of the tax rules and the role and development of financial markets in the country in question.

VII. Income Taxation of Domestic Transactions

A. In general

8. For most developing and transition countries,8 new rules for the taxation of NFIs as used in domestic transactions will likely not be a priority over the immediate next few years. Financial markets in the vast majority of non-OECD countries are not as highly developed as in OECD member countries, and correspondingly new financial instruments are not as frequently used. Indeed, even in the OECD group of countries, the use of new financial instruments is much more widespread in the handful of countries which have extremely sophisticated financial markets. The relatively low level of use of NFIs in developing and transition countries implies that any revenue losses or distortions created by less than ideal tax rules should have minimal economic significance.

A. Taxation of Individuals

9. As a practical matter, NFIs do not pose a significant problem in most developing and transition countries as far as the taxation of individuals is concerned. First, most of these countries in any event receive only a small portion of their revenues from the taxation of capital income of individuals. Moreover, in most of these countries, only a very small percentage of the population will have access to NFIs. Where such individuals seek to reduce their tax by aggressive means, they are likely to do so by using offshore accounts or nominees (which allow them to evade their tax liabilities completely, albeit in many cases illegally) rather than NFIs (which, by and large, allow only deferral of tax, not complete tax avoidance). In addition, in many developing and transition countries, capital income is subject to relatively favorable tax regimes (through low-rate final withholding taxes). In this context, use of NFIs may not be a particularly attractive tax planning tool.

A. Taxation of Companies

10. As far as taxation of companies is concerned, NFIs are likely to pose the greatest problem for countries which do not tax capital gains of companies or which subject such gains to a favorable tax rate. This is because one of the typical uses of NFIs is to convert income that would otherwise be taxable as ordinary income into capital gain. A simple

6

example is gain on disposition of a bond with original issue discount. Absent special rules, this gain might be taxable as capital gain in a country with favorable rules for capital gains. The remedy for this problem is relatively simple. General principles of tax policy argue in favor of eliminating favorable taxation of corporate capital gains, and treating all the income of a corporation as business income. Most countries have adopted such a rule, perhaps with limited exceptions such as for gains on disposition of depreciable property or on disposition of an entire business, which would not apply to transactions involving NFIs.

11. For countries that do not provide favorable treatment for corporate capital gains, NFIs pose less of a problem. The distinction between ordinary income and capital gain may still be relevant if there are limitations on capital losses, but if there is no rate differential between different kinds of corporate capital income the issue becomes one of timing: when is income on NFIs taken into account?

12. In many developing and transition countries the answer will be found in the financial accounting rules, because the rules for taxation of business enterprises are based on these accounting rules. These rules tend to be more flexible than accounting rules set forth in the tax laws themselves and may provide a basis for dealing sensibly 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.

13. By contrast, in countries which formulate their tax rules independently of accounting rules, it may be necessary to provide detailed rules for the taxation of financial instruments so that taxpayers cannot use them to avoid taxation.

14. Regardless of the treatment of capital gains, NFIs are likely to pose more of a problem in countries with complex income tax legislation. Innovative financial transactions are likely to pose challenges to the integrity of this network of statutory rules.

15. Countries which (i) do not have reduced rates (or exemption) for capital gains, (ii) base their corporate income tax on the financial accounting rules, and (iii) have kept their corporate income tax rules simple therefore may not need extensive special rules for NFIs in their domestic legislation. Of course, these countries should monitor their financial accounting rules and practices to make sure that there are no serious problems in accounting for NFIs. Accounting rules may not provide a perfect answer in all cases, but in countries where the domestic use of financial instruments is not widespread the effect on revenues from any inaccuracies in the accounting rules is likely to be far down the list of tax administration priorities.

XVI. Income Taxation of International Transactions

A. In General

7

9 See Lokken, supra note 5, at para. 118; OECD, supra note 5, at 105-06.

17. NFIs used in international transactions are likely to prove more problematic for developing and transition countries than in the domestic context. This is due to the considerations spelled out in paragraphs 19-23 below.

18. Accounting norms will not help in the international area, because rules for withholding must be based on norms specified in the tax laws.

19. Legal form makes a difference in the area of withholding. Under each country=s domestic law, as limited by tax treaties, 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 interest and dividends, but not on other contractual payments. Because taxpayers can use NFIs to manipulate the legal form of payments, the integrity of withholding taxes is likely to come under pressure.

20. In the case of certain NFIs, particularly derivatives, tax policy concerns militate against the imposition of a withholding tax, because the payments under some financial instruments may not be closely correlated with the income actually earned. This is particularly the case for swap payments. There is a risk, therefore, that if a gross basis tax is imposed at source, 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.9 Such a policy may therefore deny to domestic companies the risk-shifting benefits that new financial instruments can provide.

21. Tax treaties present an important constraint on countries= freedom of action. Treaties present two types of problems for developing countries. First, the effect of existing treaties is to preclude taxation in many cases. Second, the application of tax treaties presents difficult legal issues of construction because new financial instruments do not fit neatly into the categories contemplated by treaties. NFIs thus raise longer-term concerns about division of the tax base between source and residence countries. Because this note focuses on the medium term (say, the next five years), it does not consider the issue of possible revision of the tax treaty regime. Revision of the existing treaty framework would be a lengthy process requiring discussion and agreement among a large number of countries. In any event, this will not happen over the next few years. Thus, the note takes the existing treaty structure as a given and considers what developing and transition countries can do in the context of that structure.

22. If the domestic market is undeveloped, the bulk of NFIs used in a developing or transition country may involve cross-border payments. Moreover, domestic taxpayers

8

10 See generally OECD, supra note 5, at paras. 19-23, 47-50, 92.

11 For a discussion of the policy framework for taxing NFIs, focusing on the need to strike an appropriate balance between allowing markets to operate efficiently and guarding against tax avoidance, see John Neighbor, Taxing Financial Innovation in a Global Economy (2001) (paper presented for this meeting).

12 See OECD, supra note 5, at 101-02 (Appendix II).

13 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.

14 See OECD, supra note 5, at 103 (Appendix II).

with international connections, such as branches or subsidiaries of multinational companies, may have the best access to cross-border NFIs.

A. Use of new financial instruments for tax avoidance

23. In many, perhaps most, cases NFIs are used for legitimate commercial reasons.10 Tax rules should not discourage their use.11 However, NFIs can also be used by taxpayers B often subsidiaries of multinational groups B to avoid taxation in the countries where they operate. A few examples, set forth below, can illustrate the avoidance possibilities, but it should be kept in mind that actual transactions used for tax planning will depend on the laws and treaties of the specific countries concerned, as well as on the future ingenuity of tax planners.

24. Suppose that a hybrid instrument is treated as debt in the jurisdiction of the payor and as equity in the jurisdiction of the payee.12 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, the recipient of the income may benefit from favorable treatment for equity in the jurisdiction of its residence, for example a participation exemption.13

25. A forward contract may be used to circumvent withholding on interest. 14 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

9

15 See Lokken, supra note 5, at para. 112.

16 See Lokken, supra note 5, at para. 123. See also infra ---.

deductiblity of interest (thin capitalisation rules).

26. A subsidiary of a foreign corporation may be financed by its parent with an obligation that bears OID rather than stated interest. If the country of the issuer imposes withholding tax on payments of stated interest but not on OID then the use of the OID obligation avoids withholding.

27. A nonresident may, instead of purchasing the stock of a local corporation, enter into an equity swap agreement with a local bank.15 Under the agreement, dividends on stock owned by the nonresident in another country are swapped in exchange for the amount of dividends on stock of the local corporation.

28. Instead of borrowing money from a nonresident, a resident company may enter into a swap agreement with the nonresident whereby the nonresident makes an upfront payment to the resident and the resident makes a series of payments over a period of several years to the nonresident. Although taking the form of a swap, the transaction may be in substance a loan.16 However, if the legal characterization of the transaction as a swap is respected, the transaction may be successful in avoiding withholding tax on interest.

29. NFIs of whatever form may raise the question of transfer pricing. A nonresident related party can arrange a transaction to take place through a financial institution (so-called back-to-back transaction) so that it appears that the resident taxpayer is dealing with an unrelated financial institution. Where this institution is located in a tax haven, it may be difficult or impossible for the tax authorities to obtain information on all aspects of the transaction. In addition, because NFIs can be tailor-made, it may be difficult for the tax authorities to ascertain whether the pricing corresponds to fair market value.

A. Transfer Pricing

1. Pricing of NFIs

30. Conceptually, NFIs do not raise any new issues as far as transfer pricing is concerned. As noted in para. 30 above, however, there are important practical reasons why they may pose particular difficulties for tax administrations. The first is that it is easy for taxpayers to arrange these transactions so that they do not appear to be with a

10

17 See id. at para. 124.

18 OECD, The Taxation of Global Trading of Financial Instruments (1998).

related party.17 If, as in most cases under domestic legislation, the transfer pricing rules apply only to related-party transactions, the result is that the tax authorities may not be in a position to demonstrate that they have authority to adjust the price in the first place. Second, NFIs tend not to be standard, and it is easy for taxpayers to devise a complex instrument which makes it difficult for tax administrators to ascertain whether something is wrong with the price without doing a lot of analysis. This makes it difficult to screen cases where there is a potential problem from those that are normal. Third, the determination of the correct market price may be problematic because published information on the factors determining the price may not be available.

31. As a legislative matter, it may make sense to provide broader authority for adjustment of transfer prices in the case of transactions involving financial instruments. For example, the taxpayer could be required to show that the transaction was carried out with an unrelated party. One possibility is to impose this kind of requirement only in the case of transactions involving a tax haven. Finally, sufficient flexibility needs to be given to the tax authorities to determine the correct market price.

32. Administratively, special training may be needed so that there are specialists within the tax administration to whom tax inspectors can turn to for advice when encountering NFIs. It would be unrealistic in most developing and transition countries to train large numbers of officials to deal with these issues.

1. Taxation of Firms Engaged in Global Trading of Financial Instruments

33. In addition to the transfer pricing issues raised by NFIs themselves, transfer pricing issues are raised when it comes to taxing firms whose business is trading in financial instruments, and NFIs in particular. This issue has to do not so much with the terms of NFIs themselves, although these terms often become relevant. The concept of "global trading" reflects the business practice whereby multinational financial institutions operate in a number of locations in different countries in such a manner that their operations are interrelated, making it difficult to apply arm=s-length pricing principles. Because the subject is dealt with at length in an OECD publication,18 and because the issues raised are mostly different from those considered in this paper, only a brief mention will be made here and interested persons are referred to this OECD publication. A perusal of that publication makes it clear that the topic is complex and that effective audit techniques for firms engaged in global trading require highly trained personnel. The

11

19 See id. at 55-56; I.R.C. '475.

20 See Lokken, supra note 5, at para. 125.

highly integrated operation of such financial institutions makes it difficult to disentangle the portion of the global profits that is attributable to any one local operation. Conceptually, it is possible to undertake such a disentanglement by carefully examining the facts, but their underlying complexity makes such an exercise difficult. The difficulty is compounded by the use of substantially different accounting methods for the taxpayers concerned in different countries, with some countries accepting or requiring mark-to-market accounting and others using more general principles of accrual accounting.19 This makes it difficult to allocate a firm=s total global profits among the jurisdictions in which it operates. In the case of developing and transition countries, the issue of taxing such financial institutions will of course arise only where the financial institution has a permanent establishment in the country.

A. Association of Payments with Permanent Establishment of Payee

34. As discussed below, the existing treaty network imposes constraints on imposition of a withholding tax on payments under NFIs, and there are moreover tax policy considerations that argue against such withholding taxes. However, one way for a tax administration to avoid this issue is to show that specific NFIs where the payee is a nonresident are in fact attributable to a permanent establishment of the payee located in the source country.20 Where this is the case, the payee will be taxable on the income from the NFI on a net basis. Given the intangible nature of the products concerned, it may be difficult to show that a particular instrument is properly regarded as attributable to a local p.e. It may be the case, for example, that a transaction with a domextic customer was booked by a foreign branch or subsidiary, not the local p.e. In this respect, item (c) of paragraph 1 of article 7 of the UN Model Convention may be useful. This provision allows the source state to tax "other business activities carried on in that other State of the same or similar kind as those effected through that permanent establishment." Where the country=s domestic legislation and tax treaties contain such a provision, it may be possible for the tax administration to reach the income from NFIs even if they have been booked offshore. See also para. 34 above for problems with taxing the income of such a p.e.

A. Withholding on Original Issue Discount

35. For countries that generally impose withholding on interest paid to nonresidents, obligations with original issue discount (OID) present a problem because the accrued OID does not constitute a payment. There is also a question whether the payment of OID at maturity constitutes interest, as opposed to a capital gain. Depending on the concept of

12

21 This interpretation might not be followed, however, by countries which regard payment of discount at maturity as giving rise to a capital gain, in which case this amount would be taxable only in the residence country under treaties following the OECD or UN models.

22 See note 20 infra.

23 Australia, Canada, New Zealand, Switzerland, and the US have provisions for withholding tax in the case of nonresident holders of deep discount bonds. (See OECD, supra note 5 at 58, para. 100) All 5 countries impose withholding tax when a domestic bond issuer redeems bonds in the hands of a non-resident. Australia and Canada also impose withholding tax in cases where a resident purchases a deep discount bond from a nonresident. The US requires withholding tax on accrued interest to be deducted from any payments made before maturity. Id.

interest applicable in domestic legislation, the OID might not be considered as interest. If this is the case in a particular country, it should be easy to solve by including in the tax laws provisions that assimilate OID to interest. At the international level, the issue is whether for purposes of tax treaties OID will be treated as interest. Interpretation of treaties by the OECD supports the view that OID is interest. Thus, the OECD Commentary on article 11, para. 18, states, in relation to the definition of interest: "The term designates, in general, income from debt-claims of every kindY" Furthermore, para. 20 of the Commentary states: "YGenerally 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 issueY.." At least as far as the OECD Commentary is concerned, therefore, there seems to be a consensus that treaties following the OECD definition of interest include OID within the concept of interest.21

36. A further question is whether accrued, but unpaid, interest could be subject to withholding. 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." While some countries impose withholding tax in advance of redemption of a bond, such tax is witheld from a payment (either a periodic payment of interest or a payment made to acquire the bond from the nonresident).22

37. Despite the fact that tax treaties allow withholding on OID, the number of countries that impose withholding taxes is relatively small.23 The absence of withholding may not have been considered a serious matter if obligations with OID are rarely used in cross-border transactions. However, even if their use is rare, it seems appropriate to include withholding provisions in order to prevent tax avoidance by the perhaps small

13

24 See U.S. Treas. Reg. Sec. 1.1441-2(b)(3).

25 See Lokken, supra note 5, at para. 106.

number of taxpayers who use such obligations to avoid withholding tax on interest. While the imposition of withholding tax on OID on the same basis as other forms of interest seems appropriate as a matter of principle, it does raise some practical questions.

38. In order to equalize the treatment of OID with that of interest on conventional debts, it would in principle be necessary to withhold tax from OID as it accrues. While it would be possible to require issuers of OID to make payments of withholding tax to the treasury as OID accrues, perhaps on a quarterly basis, this might be considered unreasonable and impractical, given that the issuer is not making any payment to the holder on a current basis; moreover, the author is aware of no country that has such a rule. One alternative, at least in the case of instruments which contain both some OID and some coupon payments of interest, is to compute the tax to be withheld on the basis of the total interest accruing (OID plus coupon interest), but to limit the amount required to be withheld to the amount of interest actually paid.24

39. If OID is subject to withholding only upon maturity of the debt obligation, nonresidents may seek to avoid the withholding tax by disposing of the debt instrument to a resident prior to maturity. If there is no withholding on debt instruments held by residents, this maneuver effectively avoids tax.25 One way of dealing with this problem is to impose withholding in all events, i.e. on the same basis for residents and nonresidents. This might be a workable approach for those developing and transition countries which tax interest income of resident individuals by means of a final withholding tax. In such countries, the withholding tax generally is not final in the case of companies, which receive a credit for any withholding tax imposed and are taxed on interest as part of their income. Under such a regime, it would be necessary to provide special rules that in the case of an OID obligation, a domestic company holding the obligation at maturity would receive a credit only for the portion of the withholding tax relating to interest accruing during the period that the company held the obligation. The remaining portion of the withholding tax on the payment of OID could be considered to relate to periods that the obligation was held by a nonresident or a resident individual. Such tax would appropriately be a final withholding tax.

40. Another approach, which could be used in countries which do not generally impose a withholding tax on interest paid to residents or could be an alternative to the procedure described above, would be to require residents purchasing obligations with OID from a nonresident to withhold tax on the portion of the purchase price attributable to accrued OID.

14

26 See OECD, supra note 5, at 58 (para. 101). Under a new U.S. rule, a purchaser from a nonresident must withhold tax if the person "has actual knowledge or reason to know that the sale or exchange is part of a plan the principal purpose of which is to avoid tax." U.S. Treas. Reg. Sec. 1.441-2(b)(3). This seems like too complex a rule for developing and transition countries. It would be preferable to require any resident purchasing an obligation from a nonresident to withhold tax. If OID obligations are rare, this would not be administratively burdensome.

27 See OECD, supra note 5, at 26.

28 Lokken, supra note 5, at para. 104 concludes, however, that "the practicality of withholding taxes on discount income is doubtful".

41. Such a rule applies in Australia and Canada.26 One possible difficulty with such a rule is that if a bond is sold a number of times by a nonresident to a resident over the life of the bond, the withholding tax could be excessive.27 A remedy could be to allow the nonresident to file for a refund if the tax withheld exceeded tax computed on the portion of the OID that accrued while the nonresident held the bond. In any event, for developing and transition countries where OID obligations are seldom used and rarely traded actively, the problem of excessive withholding is not likely to be significant.

42. While imposing a withholding requirement on cross-border OID involves some complexity, the compliance and administrative costs will be small if the withholding rules rarely apply because there are few cross-border instruments with OID.28 Such withholding provisions can therefore be seen as preventing the tax avoidance that might otherwise occur in the absence of a withholding requirement. The absence of a withholding requirement might encourage taxpayers to use OID instruments purely for tax reasons. This would of course be most advantageous where the corporate income tax rules allow the issuer to deduct OID as it accrues.

43. Another alternative might be to allow no deduction for OID as it accrues, and correspondingly not to tax holders of OID obligations until they receive the income. While this would take care of abuse in the form of an issuer deduction for the OID, it would introduce a corresponding distortion in taxation of the holder of the instrument. Whenever such distortions are introduced, taxpayers tend to plan their affairs so as to take advantage of them. Therefore the preferable course of action might be to provide for taxation of OID as it accrues (allowing a deduction to the issuer and taxing the holder). But in the case of OID accruing on an obligation held by a nonresident this would mean that the withholding tax is deferred beyond the point that a deduction is allowed to the issuer. Conceivably, the benefit of this deferral could be eliminated by increasing the withholding tax rate on deferred withholding to reflect an implicit interest charge. Another alternative would be to deny a deduction for acrrued but unpaid OID on

15

29 See, e.g., I.R.C. sec. 163(e)(3) (United States), which denies an interest deduction for accrued but unpaid OID where the holder is a related nonresident person.

30 A possible exception to this conclusion may apply in the case of treaties using language in the article defining "interest" similar to the language of article 11 of the 1963 version of the OECD Model. This language refers to income that is treated as interest under the laws of the source state. If the tax legislation of the source state treats income from certain derivatives as interest income, then in the case of treaties following this language the income may be treated as interest under the treaty. See also note B infra (relating to Mexico).

31 For example, of the 630 treaties analysed in John Phillips, International Tax Treaty Networks (2000), only 272 follow the OECD Model closely with respect to the "other income" article. The treaties analysed in that work are mostly between OECD countries. Treaties involving developing countries are presumably even more likely to follow the UN Model on this point.

obligations held by nonresidents.29

A. Withholding on Income from Derivatives

1. Constraints imposed by tax treaties

44. The existing network of tax treaties places significant constraints on countries= freedom of action in imposing a withholding tax on derivatives. In most cases, under tax treaties, income from derivatives should be classified as business income, capital gain, or "other income". Under any of these characterizations, according to treaties following the OECD Model, the income would generally be taxable only in the residence country. This conclusion holds, for example, even in the case of an interest rate swap. Although the payments under the swap agreement are determined with reference to an amount of interest payable by each of the parties to the swap, the swap payments themselves are not interest. They are not payments for the use of money, there being no loan between the parties to the swap.30

45. However, many treaties do not follow the OECD Model as far as the "other income" article is concerned. Some treaties do not contain an "other income" article; therefore other income is taxable in the source state without limitation. Moreover, under the UN Model, other income arising in a contracting state may be taxed in that state. Many existing treaties follow this or a similar approach.31 Thus, a country which has followed the UN Model in its treaties will be able to impose a tax on payments under derivatives if it wishes, in circumstances where these payments are properly characterisable as other income. In such cases, it becomes important whether the income

16

32 See, e.g., Rev. Rul 87-5, 1987-1 C.B. 180 (United States).

33 See Lokken, supra note 5, at para. 123.

34 For the U.S. rules characterizing a portion of a swap as involving a loan see Treas. Reg. Sec. 1.446-3(g)(4) ("A swap with significant nonperiodic payments is treated as two separate transactions consisting of an on-market, level payment swap and a loan. The loan must be accounted for by the parties to the contract independently of the swap. The time value component associated with the loan is not included in the net income or net deduction from the swap Y, but is recognized as interest for all purposes of the Internal Revenue Code.."). Under this approach, "a level payment consisting of accrued interest and the amortized portion of principal is deemed paid by the recipient of the significant nonperiodic payment on each exchange date under the loan." Andrea Kramer, Financial Products Taxation, Regulation, and Design ' 78.04[B][4] (2001). For a discussion of the Canadian practice, see Derivatives and Financial Instruments 15 (1999).

is characterised as business income or as other income. Presumably, where a derivative is issued by a financial institution in the ordinary course of its business, the income should be regarded as business income.32 If this is the case, then even where a country follows the UN Model on the other income article, it would be prevented from imposing a withholding tax. The country could tax the income from the derivative only if attributable to a permanent establishment of the payee (see paragraph B infra).

1. Embedded interest

46. In some cases, all or a portion of a payment under a swap can properly be regarded as interest under treaties following article 11 of the OECD or UN Model. A swap agreement involving a deferred time of payment can contain an implicit interest element. Indeed, a loan can be disguised as a swap.33 A simple example involves a swap agreement whereby A makes to B a payment of 1,000, and then B pays to A an amount of 100 for 5 years and 1,100 in the sixth and final year. This is nothing but a loan at 10% annual interest, even though the payments are called swap payments. Under a rule that treated as interest the implicit interest due to differences in timing of payments under a swap, an appropriate portion of the payments would be characterized as interest. More generally, an interest element can be embedded in a swap because of deferred timing, even where the swap as a whole is not just a disguised loan.34 For example, suppose party A has a fixed interest obligation where interest is payable in April of each year, and party B has a floating rate obligation where interest is payable in May of that year. Under the agreement, B makes a payment to A (sufficient to satisfy A=s fixed-interest obligation) every April, and A makes a payment to B (sufficient to satisfy B=s floating rate obligation) every May. Because of the one-month time lag, in addition to the swap element, this agreement involves an implicit loan from B to A. This loan will involve implicit interest

17

35 See Klaus Vogel et al., Klaus Vogel on Double Taxation Conventions 738 (3rd ed. 1997) (&67a).

36 The implicit interest problem is not confined to swaps. For example, under a "deep in the money" option, one party may make a substantial up-front payment for the right to exercise the option at a favorable price, and the arrangement can be viewed as involving a loan.

which is reflected in the amount of the payment that A makes to B. If A=s state of residence imposes a tax on cross-border interest payments, then a withholding tax could be imposed on the portion of A=s payment to B that represents implicit interest, absent an exception for de minimis amounts. In this example, it is a relatively small amount of the payment, and therefore should probably be ignored, but in the example of the loan disguised a swap agreement, the amount of the disguised interest payments is clearly substantial.

47. Suppose that under the laws of the source country the implicit interest element in a swap is treated as interest and that this amount is subject to withholding. It is not completely clear whether tax treaties would be interpreted as treating this amount as interest. Paragraph 21.1 was added to the Commentary to article 11 of the OECD Model in 1995 to deal with this issue. It provides as follows: "The definition of interest in the first sentence of paragraph 3 does not normally 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." Although some commentators do not agree,35 it appears that this paragraph was intended to treat as interest those amounts that are recharacterized as interest by the source state. While the tax administrations of OECD countries will presumably follow the commentary, it remains to be seen how courts would deal with the issue if confronted with it.

48. The calculation of the implicit interest element in swap agreements is relatively complex, but again this complexity should be manageable, given that the parties to swap agreements are financially sophisticated and able to make the requisite calculations. Moreover, most swap agreements are not likely to involve an implicit interest element (de minimis implicit interest can be excluded by the legislation imposing a withholding tax).

49. Hence, developing and transition countries may wish to consider imposing a withholding tax on the implicit interest element in swap agreements or other derivatives,36 if only to forestall possible tax avoidance transactions. Taxing the interest element of derivatives may be particularly important where a country=s policy is generally to impose a withholding tax on all payments for capital invested in the country. The precise nature of the legal language needed to tax implicit interest will depend on the general structure

18

37 See Lokken, supra note 5, at para. 123. See also infra para ----.

38 See Lokken, supra note 5, para. 107.

39 For example, Singapore regards payments under an interest rate or currency swap transaction as a payment in connection with an indebtedness. See Teoh Lian Ee and Peter Loo, Singapore: Taxation of Currency Swap Payments, Derivatives and Financial Instruments 289 (1999).

40 See Carmine Rotondaro, Tax Treaty Characterization Issues of Credit Derivatives, DFI 79 (2000). Under a credit default swap the protection seller obligates itself to make a payment to the protection buyer in the event of default.

of the tax laws. Some countries will want to spell out all the details in the statute, while others may wish to include only a general statement in the statute and spell out the details in regulations. The issue should be coordinated with the general rules concerning OID, since an implicit loan under a swap can involve OID. An alternative to specific rules recharacterizing payments under a swap as implicit interest would be to rely on a general substance-over-form rule in the tax law.37

1. Imposition of withholding tax notwithstanding treaties

50. Although the vast majority of countries generally do not impose withholding on derivatives (absent those payments characterised as implicit interest),38 a few countries (e.g. Greece and Mexico) do impose a withholding tax more generally on derivatives. This may be motivated by a concern that derivatives could be used to erode the domestic tax base in the absence of a withholding tax. In particular, it could be argued that some payments under derivatives are analogous to interest,39 even though they might not come under Article 11 as currently drafted. For example, where a taxpayer enters into a fixed-rate loan and an interest rate swap, the taxpayer=s position becomes economically identical to that of another taxpayer who just borrowed on a floating rate basis. The payments made by the latter taxpayer clearly are interest. The same conclusion could follow if the swap and the loan were integrated. However, such an approach is not provided by existing treaties. Similarly, payments under a credit default swap closely resemble guaranty payments which may be considered interest under Article 11.40 Thus, at least in some cases, payments under derivatives do resemble interest, even though they might not fall under the interest article of treaties based on the UN or OECD Model.

51. If a country imposes a general withholding tax on payments under derivatives, it risks cutting off the benefits of these transactions for its residents, because the withholding tax may make the transactions unviable. However, if the country has an extensive treaty network, taxpayers may be able to avoid the withholding tax by structuring the transaction through a taxpayer resident in a treaty partner with a treaty that

19

41 Article 16A.

42 See Francisco Moguel, Tax Treatment of Financial Futures, Derivatives and Financial Instruments 253 (2000). Income Tax Law, articles 7A, 7D, 18A, 151B, 154C.

43 See J. Javier Goyeneche P., National Report: Mexico, 80b Cahiers de droit fiscal international 387, 395 (1995).

44 See id.; John S. Phillips et al., International Tax Treaty Networks (2000).

precludes the tax. The result will be that the withholding tax will in effect preclude domestic taxpayers from entering into derivative agreements with taxpayers resident in non-treaty partners, in particular with tax havens. Whether such a tax policy is appropriate is a matter of judgment. Probably it is not justified to impose such a tax unless significant tax avoidance transactions structured as derivatives run through tax havens are observed as in use in a particular country. In the absence of such an observation, it is not clear why the complexity of providing for such a tax would be justified.

52. An example of a country that has imposed such a withholding tax is Mexico. The Mexican tax code defines financial derivatives41 and the income tax law classifies derivatives as debt derivatives or capital derivatives. Amounts paid or received under debt derivatives are treated as interest for tax purposes and are subject to withholding at the same rate generally applicable to interest, except as prohibited by treaties.42 Withholding on gain on capital-related derivatives is carried out at a 20-percent rate. Mexico has a reasonably extensive treaty network, but the majority of Mexico=s treaties include in the definition of interest the following or similar language: "income which is subjected to the same taxation treatment as income from money lent by the laws of the State in which the income arises." This language (which is based on the 1963 OECD Model) appears to permit withholding on interest-related derivatives, given that amounts paid under such derivatives are treated as interest under article 7A of Mexico=s income tax law.43 With respect to treaties not containing such language, payments under derivatives are taxable in Mexico to the extent that they can be characterized as "other income", since Mexico=s treaties generally allow taxation of other income by the source state.44 (Of course, a withholding tax will be precluded for payments that are business profits not attributable to a permanent establishment of the nonresident in Mexico.)

A. Hybrid Instruments and Thin Capitalization

53. NFIs are often used in cross border transactions to take advantage of different qualifications of the instrument in the country of residence of the issuer and the holder. For example, an instrument may be treated as debt in the country of the issuer but as

20

45 For example, recent German treaties include a provision that deals with certain instances of inconsistent characterization. In particular, where such inconsistent characterization leads to exemption in Germany, this provision denies the exemption, applying a foreign tax credit instead. See Agreement Between the Federal Republic of Germany and the Republic of Lithuania for the Avoidance of Double Taxation with Respect to Taxes on Income and Capital, protocol, para. 7 (signed July 22, 1997).

46 Abgabenordnung art. 42.

47 See article 14.1(g) of corporate income tax (Law 43/1995), noted in DFI at 22 (1999).

48 See generally [TLDD and Cooper book]

equity in the country of residence of the holder. In this case, some recent treaties provide that benefits extended to equity in the country of residence of the holder will not apply.45

54. From the point of view of the issuing jurisdiction, it is not critical whether a particular instrument will qualify as a hybrid. After all, a debt instrument issued to a holder in a tax haven may not technically be a hybrid but the effects may be similar, in the sense that the issuer gets a deduction and the holder is not taxed. Instead of focusing on hybrid instruments, a better approach is a general anti-thin capitalization rule, whereby the total amount of interest deductions is limited. A discussion of the structuring of thin capitalisation rules is beyond the scope of this paper.

LV. Anti-avoidance Rules

56. A number of countries have adopted general anti-avoidance legislation. For example, Germany has long included in its tax laws a provision whereby a legal construction that is inappropriate to the economic circumstances could be disregarded.46 For example, in the case given above of a loan disguised as a swap, this provision could be invoked by the tax administration to recharacterize the arrangement as a loan. An antiavoidance provision of this kind might be useful in developing and transition countries which do not have judicially developed rules under which tax statutes will be construed so as to prevent abuse. Some countries have adopted more specific rules targeted at cross-border tax avoidance transactions. For example, Spain denies a deduction for expenses for services received corresponding to transactions carried out with residents of tax havens, except where the taxpayer proves that the expense derives from a transaction effectively performed.47

57. The precise drafting of an anti-avoidance rule or rules and their desirability are beyond the scope of this paper.48 The ramifications extend well beyond the taxation of NFIs. However, NFIs provide a situation where anti-avoidance rules might be

21

49 See Peter Mason, Solving the Issues of VAT and Financial Derivatives or It=s VAT Jim, but Not as We Know It!, 2 Derivatives and Financial Instruments 190 (2000).

particularly useful, since by definition new and flexible legal arrangements, often structured so as to avoid existing tax rules, are involved. Thus, it is recommended that developing and transition countries study the desirability of introducing appropriate anti-avoidance rules, and in particular consider the extent to which provisions governing NFIs should be set forth in the tax laws in detail, as opposed to relying on a general anti-avoidance rule. There are advantages and disadvantages of both approaches, and a combination of general and special anti-avoidance rules can also be considered.

58. In the absence of any statutory or judge-made anti-avoidance rules, countries run the risk that taxpayers will exploit lacunae in the tax laws by using NFIs, leaving little availability for the tax administration to defend itself if the general approach to construction of tax statutes is a literal one.

LIX. Value Added Tax

60. Most countries exempt financial services from VAT. This may change, but since this paper is concerned with the near term we will take the exemption of financial services as a given and evaluate the taxation of NFIs in this context.

61. One problem in this respect is the definition of financial services. These are typically defined in a fairly detailed manner by listing various types of transactions. Each country with a VAT should review its definition of financial services to make sure that transactions relating to NFIs are covered. For example, if the definition of financial services refers to transactions in "securities", this may not cover options or futures if they are not considered securities under general law. A relatively easy thing to do, therefore, is to adjust the definition of financial services where necessary in order to include transactions in NFIs.

62. A further issue is allowance of an input credit. If the supply is an exempt supply made domestically, no credit will be allowed. However, the VAT law may allow an input credit with respect to supplies made abroad, even if exempt. If this is the case, it will be necessary to ascertain the place of supply. Typically this requires a determination whether a supply is of goods or of services and of what type of services. Again, it will be necessary to review the place of supply rules to make sure that they cover transactions involving NFIs. These transactions do not typically involve a straightforward sale of property or rendering of services by one person to another for payment, but may involve reciprocal contractual obligations relating to future events.49 If they are not covered by the terminology used by existing law, then this should be adjusted.

22

LXIII. Summary of Principal Conclusions

Although some of them are applicable more generally, the following conclusions, designed to provide tax policy guidance in the short to medium term, are targeted to appropriate tax policy for developing and transition countries. Thus, references to "countries" below should be taken as referring to developing and transition countries in particular. At the same time, because each country is unique, the general conclusions will not be valid for all cases, as each country will need to devise a tax policy appropriate to its circumstances.

64. For most countries, new rules for the taxation of NFIs as used in domestic transactions will likely not be a priority over the immediate next few years. The main problems may be experienced by countries which tax capital gains at favorable rates or do not tax capital gains at all. All countries should, however, monitor their applicable accounting rules to make sure that there are no serious problems in accounting for NFIs for corporate income tax purposes.

65. Countries should be vigilant in applying transfer pricing rules to cross-border transactions involving NFIs. They should make sure that adequate legal authority exists to allow their tax administrations to adjust transfer prices where necessary, and should make sure that at least a small number of tax officials are well trained to deal with this area.

66. Effective audit techniques for firms engaged in global trading require highly trained personnel. Countries should develop a strategy for dealing with this issue in a systematic manner.

67. Countries should develop clear rules for associating NFIs with local branches (permanent establishments) of nonresidents and make sure these rules are applied consistently and diligently.

68. A general imposition of a withholding tax on payments under NFIs generally does not make sense as a matter of tax policy. Such a tax would in many cases be out of proportion to the income earned by the recipient. It would tend to choke off commercially useful hedging transactions. Neither would such a tax make sense in the context of the existing tax treaty network, since in most cases this network contemplates taxation of payments under NFIs only by the residence state.

69. However, countries do have an interest, consistently with the principles of the existing tax treaty network, in imposing withholding tax on cross-border payments under NFIs under two circumstances: (1) in the case of countries that generally impose a withholding tax on cross-border payment of interest, where the payments represent a return on invested capital (in which event they can often be characterized as interest) and

23

(2) where the payments represent excessive amounts used to siphon off earnings to related parties.

70. Countries that generally impose withholding tax on interest paid to nonresidents should consider extending this tax to original issue discount. Rules subjecting OID to withholding should include a requirement for residents acquiring obligations from nonresidents to withhold tax on the portion of the acquisition price attributable to accrued OID.

71. Countries that generally impose withholding tax on interest paid to nonresidents should consider imposing a withholding tax on the implicit interest element in swap agreements or other derivatives, subject to an exception for de minimis amounts.

72. In treaty negotiations, countries wishing to impose withholding taxes as described in paragraphs 68 and 69 may wish to consider including language such as that in the 1963 OECD Model version of Article 11 so as to make clear their authority to impose such a withholding tax.

73. The use of hybrid instruments on a cross-border basis to erode the domestic tax base can be appropriately countered by effective thin capitalisation rules.

74. Given that NFIs can be used to structure transactions whose legal form deviates from their economic substance, countries should consider the introduction of appropriate anti-avoidance legislation to allow their tax administrations to challenge the recharacterize transactions according to their economic substance in appropriate cases.

75. Countries should review their legislation in the cases of taxes other than income tax to make sure that NFIs are appropriately dealt with. For example, in the case of VAT, the definition of financial services and the place-of-supply rules should be reviewed to make sure that they appropriately cover transactions involving NFIs.