4.64 is taxed in Year 1 and 4.86 is taxed in Year 2 (see Case RÅ 1994 ref 19).
Hänvisas från p. 6 (s. 120)
THE ECONOMIC SUBSTANCE OF DERIVATIVES.........................15
1.2.1 AF..................................................................15s. 2
2.2.2 IR................................................................................15s. 2
3.2.2.1 The Haig-Simons Concept of Income..........................................15s. 2
4.2.2.2 Risk.............................................................................................16s. 2
5.2.3 D.......................................................................................20s. 2
6.2.3.1 Definition....................................................................................20s. 2
7.2.3.2 Derivative Trade.........................................................................21s. 2
8.2.3.3 The Purpose of Derivative Trade................................................22s. 2
9.2.4 P-FD................................................................23s. 2
10.2.4.1 Forwards.....................................................................................23s. 2
11.2.4.2 Futures........................................................................................26s. 2
12.2.4.3 Swaps..........................................................................................26s. 2
13.2.4.4 Using Price-Fixing Derivatives to Transfer Risk........................27s. 2
14.2.5 P-ID.........................................................29s. 2
15.2.5.1 Options........................................................................................29s. 2
16.2.5.2 Using Price-Insurance Derivatives to Transfer Risk..................35s. 2
17.2.6 FE....................................................................37s. 2
18.2.6.1 No-arbitrage...............................................................................37s. 2
19.viiis. 2
20.2.6.2 Basic Building Block Financial Instruments...............................41s. 3
21.2.6.3 Synthetics....................................................................................43s. 3
22.2.7 N-TFI....................................47s. 3
23.2.7.1 Financial Innovations.................................................................47s. 3
24.2.7.2 Composite Contracts...................................................................47s. 3
25.2.8 C......................................................................................49s. 3
TAX ARBITRAGE AND THE GENERAL STRUCTURE OF THE
SWEDISH INCOME TAX SYSTEM.............................................................51
1.3.1 LF............................................................................51s. 3
2.3.2 TA..................................................................................51s. 3
3.3.2.1 Defining Tax Arbitrage...............................................................51s. 3
4.3.2.2 Realization vs. Fair-value...........................................................52s. 3
5.3.2.3 The Ability to Pay Income Taxes.................................................54s. 3
6.3.2.4 Income.........................................................................................55s. 3
7.3.2.5 Timing Arbitrage.........................................................................55s. 3
8.3.3 FGSSs. 3
9.CITS.................................................................58s. 3
10.3.3.1 Income from Business.................................................................58s. 3
11.3.3.2 Ordinary Business.......................................................................58s. 3
12.3.3.3 Financial Instruments and Ordinary Business...........................59s. 3
13.3.3.4 Security Business........................................................................60s. 3
14.3.3.5 Income from Ordinary Business and Income from Capitals. 3
15.Management...............................................................................................61 ixs. 3
16.3.4 IC’CM.......................63s. 4
17.3.4.1 Scope...........................................................................................63s. 4
18.3.4.2 Capital Gains and Capital Losses..............................................63s. 4
19.3.4.3 Dividends....................................................................................65s. 4
20.3.4.4 Interest........................................................................................66s. 4
21.3.4.5 Income from Non-Financial Items..............................................70s. 4
22.3.4.6 Expected Income or Expenses and Windfall Gains or Losses.....70s. 4
23.3.4.7 Inconsistencies............................................................................71s. 4
24.3.5 C......................................................................................73s. 4
DERIVATIVES........................................................................................75
1.4.1 TBLF..........................................75s. 4
2.4.2 DD.......................................................................76s. 4
3.4.2.1 Derivatives – Financial Instruments or Wagering Contracts?...76s. 4
4.4.2.2 Forwards.....................................................................................77s. 4
5.4.2.3 Options........................................................................................78s. 4
6.4.2.4 Similar Contracts........................................................................79s. 4
7.4.2.5 Option-Like Contracts................................................................80s. 4
8.4.3 TID..................................................82s. 4
9.4.3.1 Similarities in the Income Tax Treatment of Capital Assetss. 4
10.and Derivatives..........................................................................................82s. 4
11.4.3.2 Capital Gains and Capital Losses..............................................83s. 4
12.4.3.3 Forwards.....................................................................................83s. 4
13.4.3.4 Options........................................................................................88s. 4
14.xs. 4
15.4.3.5 Option-Like Contracts................................................................91s. 5
16.4.3.6 Derivatives with the Issuing Company’s Own Shares ass. 5
17.the Underlying..........................................................................................92s. 5
18.4.4 DTA....................................................93s. 5
19.4.4.1 Tax Arbitrage Opportunities.......................................................93s. 5
20.4.4.2 Hybrid Instruments and Synthetic Instruments...........................93s. 5
21.4.4.3 Derivatives as Hybrid Contracts.................................................94s. 5
22.4.4.4 Using Derivatives in Synthetic Instruments................................98s. 5
23.4.4.5 Expected-Return Taxation........................................................100s. 5
24.4.5 C....................................................................................101s. 5
METHODS TO TAX THE PAYOFFS FROM HYBRID
INSTRUMENTS.............................................................................................103
1.5.1 DCC......................................103s. 5
2.5.2 TPHI...........................104s. 5
3.5.2.1 Contingent Debt Instruments....................................................104s. 5
4.5.2.2 Two Types of Hybrid Instruments.............................................104s. 5
5.5.2.3 Three Methods..........................................................................105s. 5
6.5.2.4 The Efficiency of the Three Methods.........................................106s. 5
7.5.3 BESITs. 5
8.S.........................................................................................................110s. 5
9.5.3.1 The “Residual Method”............................................................110s. 5
10.5.3.2 Income Tax Treatment of Units.................................................110s. 5
11.5.3.3 Units in Relation to other Contingent Debt Instruments...........111s. 5
12.5.4 C....................................................................................112 xis. 5
COMPOSITE CONTRACTS.................................................................113
1.6.1 CC–CBBs. 6
2.BFI.................................................................113s. 6
3.6.2 ICC...................................114s. 6
4.6.2.1 Capital Raising Contracts.........................................................114s. 6
5.6.2.2 Bonds Combined with Warrants...............................................115s. 6
6.6.2.3 Convertibles..............................................................................115s. 6
7.6.2.4 Income Tax Treatment of Bonds Combined with Warrantss. 6
8.and Convertibles......................................................................................117s. 6
9.6.2.5 Debentures................................................................................120s. 6
10.6.3 N-ICC...........................123s. 6
11.6.3.1 A Case Law Survey...................................................................123s. 6
12.6.3.2 Equity Index-Linked Zero-Coupon Bond..................................124s. 6
13.6.3.3 Real Zero-Coupon Bond...........................................................126s. 6
14.6.3.4 Foreign Exchange Index-Linked Bond.....................................129s. 6
15.6.3.5 Reverse Convertible..................................................................130s. 6
16.6.3.6 “Equity Basket”........................................................................134s. 6
17.6.3.7 Swaps........................................................................................135s. 6
18.xiis. 6
19.6.3.8 Equity Index-Linked Coupon Bond...........................................139s. 7
20.6.3.9 Income Tax Treatment of Hybrid Composite Contracts...........141s. 7
21.6.4 C....................................................................................143s. 7
SYNTHETICS.........................................................................................145
1.7.1 DUS......................................................145s. 7
2.7.2 TNSU...................................145s. 7
3.7.2.1 Defining Synthetics...................................................................145s. 7
4.7.2.2 The Principle Differences Between Composite Contractss. 7
5.and Synthetics.........................................................................................146s. 7
6.7.2.3 Taking Apart and Putting Together..........................................147s. 7
7.7.2.4 Tax Arbitrage and Hedging......................................................148s. 7
8.7.2.5 Integration................................................................................148s. 7
9.7.3 T-DUS.....................................................150s. 7
10.7.3.1 Two Types of Tax Arbitrage Opportunities...............................150s. 7
11.7.3.2 Replicating the Payoff from Existing Financial Instruments....151s. 7
12.7.3.3 Straddles...................................................................................154s. 7
13.7.4 H............................................................................................159s. 7
14.7.4.1 Theory and Practice..................................................................159s. 7
15.7.4.2 Income from Derivatives used for Hedging - Theory................160 xiiis. 7
16.7.4.3 Income from Derivatives used for Hedging – Practice...........162s. 8
17.7.5 C....................................................................................169s. 8
IAS 39 – MEASURES TO PREVENT TAX ARBITRAGE?..............171
1.8.1 SITIAS39.........................................171s. 8
2.8.2 MPTAOs. 8
3.RFI........................................................172s. 8
4.8.2.1 Abolishing the Realization Approach?.....................................172s. 8
5.8.2.2 Taxing Financial Instruments Based on a Fair Values. 8
6.Approach..................................................................................................173s. 8
7.8.2.3 Legal Classification Based on Economic Substance.................176s. 8
8.8.3 MRHI...179s. 8
9.8.3.1 Hybrid Instruments and Tax Arbitrage Opportunities..............179s. 8
10.8.3.2 Distinguishing Between Regular Derivatives and Derivativess. 8
11.as Hybrid Instruments..............................................................................180s. 8
12.8.4 B.....................................................................................182s. 8
13.8.4.1 Embedded Derivatives..............................................................182s. 8
14.8.4.2 Closely Related Contracts.........................................................183s. 8
15.8.4.3 Measuring the Building Blocks of Composite Contracts..........184s. 8
16.8.4.4 Bifurcation Based on Economic Substance...............................185s. 8
17.8.5 H............................................................................................186s. 8
18.xivs. 8
19.8.5.1 Neutral Treatment of Various Hedging Strategies....................186s. 9
20.8.5.2 Hedging as an Exception..........................................................187s. 9
21.8.5.3 Qualifying for Hedge Accounting.............................................187s. 9
22.8.5.4 Hedge Accounting Rules – an Optional Set of Rules................188s. 9
23.8.5.5 Synthetics that are not Hedge Relationships.............................189s. 9
24.8.6 C....................................................................................190s. 9
SUMMARY AND GENERAL FINDINGS...........................................193
1.9.1 DSIT...............................193s. 9
2.9.2 TESCI...................194s. 9
3.9.2.1 Income Classification...............................................................194s. 9
4.9.2.2 Basic Building Block Financial Instruments.............................194s. 9
5.9.3 TAO......................................................195s. 9
6.9.3.1 Recognition of Income..............................................................195s. 9
7.9.3.2 Financial Instruments and their Building Blocks.....................196s. 9
8.9.4 PI.................................................................196s. 9
9.9.4.1 Possible ways to Prevent Tax Arbitrage Opportunities............196s. 9
10.9.4.2 Defining Derivatives.................................................................197s. 9
11.9.4.3 Bifurcation................................................................................197s. 9
12.9.4.4 Hedging.....................................................................................198s. 9
13.9.4.5 Taxing Derivatives De Lege Ferenda.......................................199s. 9
14.9.5 CR....................................................................199s. 9
REFERENCES...............................................................................................201
1.xvs. 9
Abbreviations
1.AG Application Guidance BC Basis for Conclusion BFN Bokföringsnämnden BIS Bank of International Settlement CA Company Act Cf. Confer COM (European) Commission CPI Consumer Price Index EATLP European Association of Tax Law Proffessors EC European Community Ed. Edition EU European Union et al. et alii IAS International Accounting Standards IASB International Accounting Standards Board IFRIC International Financial Reporting Interpretations Committee IFRS International Financial Reporting Standards IE Illustrative Examples IG Guidance on Implementing IAS 39 IN Introduction ISDA International Swaps and Derivatives Association ITA Income Tax Act JWG Financial Instruments Joint Working Group of Standard Setters No. Numero MM Modigliani and Miller OECD Organization for Economic Co-operation and Development OTC Over the counter p. page pp. pages RegR Regeringsrätten RR Redovisningsrådet RÅ Regeringsrättens årsbok SOU Statens Offentliga Utredningar USD United States Dollars Vol. Volume xviis. 11
Introduction
The Subject
1.Derivative trading, if not the largest business in the world, is certainly among the largest. As of April 2004, the Bank for International Settlement (BIS) calculated the daily turnover in over-the-counter (OTC) derivative markets at approximately 2.41 trillion US dollars (USD). In the financial literature, the OTC derivative market is estimated to be approximately five times the USD value of the exchange traded derivative market. In April 2004, the combined total daily turnover in these two derivative markets was approximately 2.9 trillion USD. To put this number into perspective, the gross national product of Sweden for 2004 was 321.4 billion USD: less than one hour of derivative trading!s. 13
2.The nature of derivatives makes them well suited for risk hedging or for leveraging the payoff possibilities of traditional financial instruments like bonds. Depending on how their intended use, derivatives may be traded on a stand-alone basis or as implanted components in traditional financial instruments. Because of this variation, it is sometimes difficult to identify the existence of a derivative in relation to a financial instrument. As a consequence, the legal treatment of a derivative sometimes varies depending on whether it appears on a stand-alone basis or as a component in a separate financial instrument. This is evident in the Swedish income tax system. 1s. 13
3.The Swedish income tax treatment of derivatives and other financials. 14
4.instruments is based on the legal form of these instruments. This legal form iss. 14
5.not systematically related to the economic substance of the instruments. For thiss. 14
6.reason two identical derivatives may be treated differently depending on thes. 14
7.context in which they appear – on a stand-alone basis, or as a component of as. 14
8.separate financial instrument. As a result, the legal classification gives rise tos. 14
9.situations in which the payoffs from two financial instruments with differents. 14
10.legal forms but identical economic substances are taxed differently. In theses. 14
11.situations there is a possibility for a tax subject that wants to invest in a certains. 14
12.economic substance to choose the financial instrument for which the payoff iss. 14
13.taxed most favorable. Consequently, the income taxation of the payoff from thiss. 14
14.investment becomes arbitrary, thereby creating opportunities for tax arbitrage.s. 14
15.In summary, although derivatives may be the most traded item in the world,s. 14
16.the Swedish income tax system has not yet found methods of dealing with theses. 14
17.instruments in a way that eliminates possible tax arbitrage. Considering thes. 14
18.volume of the derivative trade, finding such methods ought to be an urgents. 14
19.matter.s. 14
Study Purpose and Delimitation
Purpose
1.Although it appears as if the taxation of derivatives and other financials. 14
2.instruments is a critical issue within Swedish income taxation policy, it is ans. 14
3.issue that essentially has been left outside present research. Therefore, thes. 14
4.general purpose of this study is to establish the Swedish income tax treatment ofs. 14
5.derivatives and to ascertain the extent to which this treatment provides taxs. 14
6.arbitrage opportunities. A further aim is to present and evaluate methods ofs. 14
7.preventing existing tax arbitrages.s. 14
Delimitation
1.Depending on the nature of the tax subject, the Swedish income tax treatment ofs. 14
2.derivatives and other financial instrument differs. In this study, focus is on thes. 14
3.income tax treatment of instruments held by non-financial companies becauses. 14
4.they are end users of the derivatives and other financial instruments. As as. 14
5.consequence, the income tax treatment of the instruments is, in principle,s. 14
6.dependent on how they are used by the company: as part of the company’ss. 14
7.ordinary business or for purpose of capital management. According to thes. 14
8.Swedish income tax system, income generated by a company’s ordinarys. 14
9.2 business is computed in a different way from company income generated by capital management; the latter is computed similar to the way individuals compute their capital income. Thus examining the income tax treatment of derivatives and other financial instruments from the perspective of non-financial companies yields information that is relevant for these companies; this information is highly likely to be useful for individuals engaged in the trading of financial instruments.s. 14
10.Most non-financial companies are also closely held companies, and the Swedish income tax system prescribes special provisions for them, relating to the distribution of profit to the owner(s). However, these provisions are of limited relevance to the income tax issues dealt with in this study, and are not taken into account.s. 15
11.An examination of the income tax treatment of derivatives and other financial instruments covers, in principle, innumerable and varied instruments, and an attempt to examine them would be endless. Therefore, this study primarily focuses on the general structures of the income tax system related to the relevant instruments. Special attention is paid to the basic building blocks of financial instruments: credit-extension instruments and derivatives.s. 15
12.Also outside the scope of this study are derivatives used within employee incentive plans, such as employee stock option programs. This decision is based on the fact that derivatives used in employee incentive plans are modified in a way that makes them different from, and not particularly relevant to derivatives as defined in this study. In addition, derivatives used in employee incentive plans are covered far more extensively in the Swedish legal literature than are derivatives that are not part of these plans. Thus to achieve the aim of contributing to the common knowledge on the taxation of derivatives, it appears appropriate to focus on derivatives that are not used in employee incentive plans, about which very little has been written.s. 15
13.The international trade in derivatives and other financial instruments is enormous. Thus income from these instruments is subject to cross-border income tax issues – problems arising when applying tax treaties to eliminate international juridical double taxation of income, for example. Although crossborder income tax issues related to derivatives and other financial instruments is an issue deserving future research, it is not a subject covered in this study 3s. 15
Method and Material
Interdisciplinary Study
1.The main objective of this study is to establish the Swedish income taxs. 16
2.treatment of derivatives and to examine whether or not this treatment containss. 16
3.tax arbitrage opportunities. Generally, tax arbitrages occur when the economics. 16
4.substance of two financial instruments is identical, although their legal formss. 16
5.differ. Consequently, in order to fulfil the purpose of the study, it is necessary tos. 16
6.consider the legal form as well as the economic substance of the financials. 16
7.instruments that are examined.s. 16
8.To establish the legal form of a financial instrument within the area ofs. 16
9.Swedish income taxation, I utilize a traditional legal method, the content ofs. 16
10.which is presented below. Because the traditional legal method cannot be useds. 16
11.to examine the economic substance of financial instrument, I use financials. 16
12.theory to do so. Furthermore, fulfilling the aim of this study required me to finds. 16
13.and apply methods to prevent the existing tax arbitrages connected withs. 16
14.derivatives and other financial instruments. For this purpose, I consulteds. 16
15.international accounting standards on financial instruments as detailed by thes. 16
16.International Accounting Standard Board (IASB). Consequently, in addition tos. 16
17.drawing upon traditional legal material used to establish the law in relation tos. 16
18.the income tax treatment of derivatives and other financial instruments, I alsos. 16
19.considered the finance literature and various materials on financial accounting.s. 16
20.Tax law, finance, and financial accounting are usually conceptualized ass. 16
21.separate academic disciplines in which research is conducted independent ofs. 16
22.other academic disciplines. However, the character of the subject dealt with ins. 16
23.this study makes it necessary to include all three disciplines. Consequently, thiss. 16
24.study is, to some extent, interdisciplinary. That said, this study’s primary focuss. 16
25.is on tax law – in particular, Swedish tax law – and its main contributions are ins. 16
26.these areas.s. 16
Comments on the Application of a Traditional Legal Method
Interpretation of Legislation
1.The general method used throughout this study is a traditional legal methods. 16
2.involving an interpretation of the legislation by means of legal material:s. 16
3.preparatory works, case law, and additional legal sources such as the relevants. 16
4.literature. The following sections indicate how this legal material is used ins. 16
5.this study.s. 16
6.4s. 16
Preparatory Works[^21]
1.In the Swedish legal literature, there appears to be a general understanding that the Swedish Supreme Administrative Court and lower Swedish administrative courts closely follow what is stated in the preparatory works when interpreting income tax legislation.However, although the rule of law – nullum tributum sine lege – implies that preparatory works are to be considered only when they are not in conflict with the general meaning of the legislation, the weight to give statements in preparatory works when interpreting income tax legislation may still be questioned. In this study, preparatory works are employed as a means of interpretation in situations in which the meaning of legislation is ambiguous. Statements from preparatory works are considered to the extent it appears reasonable and corresponds to the general meaning of the interpreted legislation.s. 17
2.When interpreting the Swedish Income Tax Act (hereinafter referred to as ITA) with references to preparatory works, it is not always evident which preparatory works to employ. The ITA resulted from an attempt to improve the structure of income tax legislation and make the language coherent. However, much of the material contents of the ITA legislation were established in its predecessors: the Swedish Municipal Income Tax Act and the Swedish National Income Tax Act. These prior acts were subject to major material changes during the income tax reform of 1990. Therefore, the reasons for the design and structure of much of today’s income tax legislation are presented in the government bills that founded that reform. As a consequence, these government bills are relevant when interpreting the ITA.s. 17
3.In addition to government bills, official government reports are consulted for reasons of interpretation. However, unlike government bills, official government reports have not been accepted by the Swedish Parliament and are of a lower rank in a legal hierarchy.s. 17
Case Law
1.In accordance with the Instrument of Government, Swedish courts have been given the authority to make the ultimate decision on legal matters within the 5s. 17
2.jurisdiction of Sweden. Decisions carried out by the Supreme Administratives. 18
3.Court are given precedence.s. 18
4.Although the lower courts are not formally obliged to judge in accordances. 18
5.with a similar issue dealt with in a precedent court decision, adherence to suchs. 18
6.decisions is generally without exceptions. Thus although it may be possible tos. 18
7.argue against the interpretation on which a precedent-setting court decision iss. 18
8.based, the legal status of the decision is difficult to question. In other words,s. 18
9.precedent-setting court decisions establish the law within the limits of thes. 18
10.decision, making precedent-setting court decisions superior to preparatory workss. 18
11.in situations in which they are contradictory.s. 18
12.Regarding the appeal system, a leave of appeal is required in order for a cases. 18
13.that has been decided by an administrative court of appeal to be accepted fors. 18
14.review by the Supreme Administrative Court. However, without the need fors. 18
15.leave to be granted, the Supreme Administrative Court also provides precedent-s. 18
16.setting court decisions on income tax issues ruled by the Board of Advanceds. 18
17.Tax Rulings (hereinafter referred to as the Board).s. 18
18.The Board gives advanced ruling on tax issues, but is by definition not as. 18
19.court. However, the precedence status of judgments by the Supremes. 18
20.Administrative Court, previously dealt with by the Board, is no different froms. 18
21.cases granted leave from an administrative court of appeal.s. 18
22.In this study, income tax legislation is interpreted with references to casess. 18
23.decided by the Supreme Administrative Court. Case law from the administratives. 18
24.courts of appeal, and rulings from the Board not subsequently decided by thes. 18
25.Supreme Administrative Court, is given a limited value. The cases referred to ins. 18
26.this study have been collected systematically by relevant databases. Casess. 18
27.decided after July 15, 2007 have not been considered.s. 18
Additional Legal Sources – Literature
1.The subject of this study – the income tax treatment of derivatives and others. 18
2.financial instruments from the perspective of Swedish non-financial companiess. 18
3.– has not previously been dealt with in a coherent scholarly study. However,s. 18
4.several of the relevant issues have been elaborated on in articles published in thes. 18
5.two major tax journals in Sweden: Svensk Skattetidning and Skattenytt.s. 18
6.Furthermore, Rutberg, Rutberg and Molander published a book, Beskattning avs. 18
7.värdepapper (1997), which deals comprehensively with the Swedish income taxs. 18
8.treatment of financial instruments. Also Tivéus regularly updates his book, Skatts. 18
9.6 på kapital, dealing with many of the issues covered in this study. In comparison to this study, these books take a more practical perspective on the issues dealt with. However, together with relevant articles published in Svensk Skattetidning and in Skattenytt, they are the most relevant additional legal sources to draw upon considering that the traditional legal method is applied in this study.s. 18
Comments on the use of Financial Literature
1.The general finance literature referred to in this study is a selection of the most common literature in the area of derivatives and financial instruments, and in the area of corporate finance. This literature provides what I consider to be a general understanding of a certain issue from a financial perspective. Because the referenced literature is among the most accepted internationally, I consider it to be a sound basis for this study. The financial literature on more specific issues – such as risk or arbitrage – has been selected systematically from various data bases – primarily JSTORE Business.s. 19
Comments on the use of Materials on Financial Accounting
Materials on Financial Accounting
1.In Chapter 8 of this study the international accounting standard, IAS 39 Financial Instruments: Recognition and Measurement, is used as a source to establish how derivatives and other financial instruments are treated in accordance with International Financial Reporting Standards (IFRS). The provisions of this standard are labelled under the following headings: Introduction, the actual Accounting Standard, Application Guidance, Basis for Conclusions, Dissenting Opinions, Illustrative Examples, and Guidance on Implementing IAS 39. Provisions presented under any of these headings deal with how to recognize or measure financial instruments; yet it is not evident how and when to use them. Therefore, in following five sub-sections I provide a brief explanation of how different parts of the accounting standard have been dealt with in this study. The standard referred to is IAS 39, as of January 1, 2007.s. 19
Introduction
1.The Introduction is of explanatory character; it briefly describes the content of the standard and the main changes from its previous draft. Thus paragraphs in the Introduction are not used for purposes of establishing the actual treatment of 7s. 19
2.financial instruments in a company’s financial reports; rather they are used ass. 20
3.guidance, explaining the background to the present standard.s. 20
The Accounting Standard and Application Guidance
1.The actual Accounting Standard follows the Introduction section. Somes. 20
2.paragraphs are written in bold, whereas others are written in regular font. Thes. 20
3.former indicates the main principles, but has the same authority as any others. 20
4.paragraph within the standard.s. 20
5.Compared to Swedish accounting legislation and to national accountings. 20
6.standards, paragraphs of IFRS are highly detailed. Furthermore, the paragraphss. 20
7.are accompanied by mandatory Application Guidance described in even mores. 20
8.detailed paragraphs. How to apply Paragraphs 10 to 13 of IAS 39 on embeddeds. 20
9.derivatives, for instance, is described in detail in Paragraphs AG 27 to AG 33Bs. 20
10.of IAS 39. Consequently, to appreciate how to deal with embedded derivativess. 20
11.according to IAS 39, it is necessary to consult not only the relevant paragraphss. 20
12.in the actual standard, but also the paragraphs dealing with the issue in thes. 20
13.accompanying Applications Guidance. In this study, the paragraphs of the actuals. 20
14.accounting standard are considered to be the primary source when establishings. 20
15.the treatment of financial instruments according to IFRS. However, in situationss. 20
16.in which an issue is also dealt with in the Application Guidance, the paragraphss. 20
17.therein are always consulted in order to interpret the accounting standards. 20
18.correctly.s. 20
Basis for Conclusion, Preface to IFRS, and the IASB Framework
1.Although the paragraphs in the IFRSs are extremely detailed, there may still bes. 20
2.situations in which it is not perfectly obvious how the standards are to bes. 20
3.applied. In such situations, the IASB indicates that the paragraphs shall be read:s. 20
4.…in the context of its objective and the Basis for Conclusions, the Prefaces. 20
5.to International Financial Reporting Standards and the Framework fors. 20
6.the Preparation and Presentation of Financial Statements.s. 20
7.Basis for Conclusion is a summary of the considerations IASB used in decidings. 20
8.on how to draft the present accounting standard. For example, the reason fors. 20
9.permitting the use of a fair-value option, as stated in Paragraph 9, IAS 39, iss. 20
10.explained in Paragraphs BC 71 to BC 76B, IAS 39. Dissident Opinions ares. 20
11.published together with the Basis for Conclusion. Neither of these documents iss. 20
12.part of the accounting standard; the documents are solely used as a means fors. 20
13.interpretation.s. 20
14.8s. 20
15.The Preface to IFRSs was approved in 2002 and generally sets out the objectives of IASB. For instance, the Preface states that an objective of IASB is to develop accounting standards in order: “…to help participants in the various capital markets of the world and other users of the information to make economic decisions.” Therefore, using the Preface to IFRSs as a means of interpretation, it appears that the information provided by IFRSs primarily serves the needs of investors rather than the needs of creditors, for example.s. 21
16.The present version of the IASB Framework was adopted in 2001 and generally establishes the concepts that underlie international accounting standards. Furthermore, it thoroughly explains concepts that are commonly used in the IFRSs. For instance, in IAS 39, the term “financial asset” is defined with reference to the term “asset”, which is not defined in the standard. In the IASB Framework, however, an asset is defined as a resource controlled by a company as a result of a past event, and from which future economic benefits are expected. Consequently, to understand the concept of financial asset as used in IAS 39, it is necessary to interpret the term with reference to the IASB Framework.s. 21
Illustrative Examples and Guidance on Implementing IAS 39
1.Illustrative Example and Guidance on Implementing IAS 39 are presented as appendixes to IAS 39. These documents are not formally part of the accounting standards, but provide a great number of examples helpful when applying the standard to various situations. Examples in the Guidance are sorted into categories, each of which deal with specific issues – definition, measurement, and hedging, for example – usually formulated as illustrative questions and answers intended as guidance in situations similar to those explicitly dealt with in the example.s. 21
2.In this thesis, Illustrative Examples and Guidance on Implementing IAS 39 are consulted in situations in which an issue is ambiguous, that is, not yet settled in primary sources: the paragraphs of the actual accounting standard or in the paragraphs of the Application Guidance. Furthermore, some of the examples presented in the Guidance on Implementing IAS 39 are used in this study to illustrate how certain regulations in an accounting standards are to be applied.s. 21
Interpretations
1.The International Financial Reporting Interpretations Committee (IFRIC) publishes Interpretations of IFRSs. Interpretations approved by the IASB are part of IFRS and have the same authority as accounting standards. In relation 9s. 21
2.to the issues dealt with in this study, the following Interpretation is relevant:s. 22
3.IFRIC Interpretation 9, Reassessment of Embedded Derivatives.s. 22
Some Terminological Issues
Analytical Framework: Finance
1.Because of the interdisciplinary character of this study, material from variouss. 22
2.academic disciplines – tax law, finance, and financial accounting – has beens. 22
3.used. This has caused some terminological inconvenience. For example, thes. 22
4.term “financial instrument” is defined differently in the three disciplines. In thes. 22
5.Swedish income tax regulations, the contents of a financial instrument varys. 22
6.depending on the context in which it is used. According to internationals. 22
7.accounting standards (IFRS), the term “financial instrument” is defineds. 22
8.independent of the context and refers solely to its contractual characteristics. Ins. 22
9.finance, the term is used as a general reference to contracts involving a financials. 22
10.obligation: bonds, loans, and derivatives, for example. Although, all threes. 22
11.interpretations of the term “financial instrument” refer to similar contracts, its. 22
12.would be incorrect to say that they are identical. Given the interdisciplinarys. 22
13.nature of this study, there is some merit in attempting to take into account thes. 22
14.context in which the term “financial instruments” is used. However, I believes. 22
15.that such distinctions would be more confusing than helpful. Therefore, the terms. 22
16.and all other terms (like “derivative”) that have been defined slightly differentlys. 22
17.in the three different disciplines are used in the way they appear in finance,s. 22
18.unless stated otherwise. The financial context has been chosen because it is thes. 22
19.context of the analytical framework of this study.s. 22
Some Commonly Used Terms
1.Terminology developed in relation to financial instruments, in a financials. 22
2.context, is sometimes unknown to persons unfamiliar with finance. Becauses. 22
3.some readers of this study may have trouble understanding some of thes. 22
4.terminology, I try to explain in this section the most commonly used terms nots. 22
5.typically in the vocabulary of a tax lawyer. In addition, most of the finances. 22
6.10 literature involves comprehensive glossaries of terms that could be helpful for readers unfamiliar with the finance terminology.s. 22
7.The most commonly used terms in this study are “financial instrument” and “derivative”. The contents of these terms are defined in Section 2.3.1, Chapter 2, and are not further elaborated upon here. It is worth mentioning, however, that because a derivative is a financial instrument, a reference to a financial instrument may be a reference to a derivative. Furthermore, as illustrated in the next chapter, derivatives may be implanted components in separate financial instruments, and not derivatives as such. In this study, such separate financial instruments are referred to as “financial instruments”. Thus a reference to a “derivative” in this study always refers to a stand-alone derivative.s. 23
8.The value of a derivative typically changes because the value of its underlying variable. The underlying variable may be an asset or an index, or something else. In the financial literature, the underlying variable of a derivative is generally referred to as the underlying of the instrument. Thus in this study, I also use “underlying” as a noun.s. 23
9.For income tax purposes, the yield of a financial instrument is classified as, for instance, ordinary income or expenses, capital gains or losses, or interest income or expenses. Depending on the classification, the income tax treatment of the yield differs. Therefore, this terminology cannot be used to explain the economic substance of a financial instrument in a neutral way, an explanation that is necessary in order to be able to analyze the income tax treatment of the financial instrument. As a consequence, I use the tax-neutral term payoff as a general reference to the positive or negative return of financial instruments.s. 23
10.Finance terminology that has not been commented on in this section is explained in the context connected to the first appearance of the term in the study. As a general rule, the terminology is in accordance with the general meaning in a financial context.s. 23
The Realization Approach and the Fair-Value Approach
1.An essential issue in this study is timing arbitrages – those that are a result of similar payoffs that are taxed in different income periods. In order to explain how and why timing arbitrages exist in the Swedish income tax system, I refer to a realization approach and a fair-value approach. In this study, these approaches represent the extremes of several different methods for income recognition. Thus they shall not be considered as references to any present method of income recognition – although they are in many ways identical to the 11s. 23
2.methods used – but solely as pedagogical tools facilitating the understanding ofs. 24
3.timing arbitrage.s. 24
Language
1.The income tax treatment of derivatives and other financial instrumentss. 24
2.challenges not only the Swedish income tax system, but it recognized as as. 24
3.problem in other jurisdictions. The principal problems appear to be of a similars. 24
4.character. Therefore, an analysis of the subject from a Swedish perspective ands. 24
5.a presentation of possible solutions to identified problems may be of interest tos. 24
6.an international audience. For this reason, the study is written in English.s. 24
7.However, Swedish legal terms are sometimes difficult to translate intos. 24
8.English. One example is the Swedish term, “termin”, which refers to derivativess. 24
9.generally known as forwards and futures in English. This term has a wider scopes. 24
10.than the English equivalent; therefore, it cannot be properly translated by as. 24
11.single word. As a result, the Swedish word has been used as a suffix to the mosts. 24
12.similar English word: forward. Thus in this study, references to a financials. 24
13.instrument that is designated to be a “termin” in Swedish are written as “forwards. 24
14.(termin)”.s. 24
15.Nevertheless, in most cases the situation has been the opposite: some Englishs. 24
16.words do not have Swedish equivalents. In fact, the English language hass. 24
17.incorporated new terminology concerning derivatives and other financials. 24
18.instruments, whereas the Swedish language has not. Therefore, the difficultiess. 24
19.related to the translation of Swedish words into English would likely be greaters. 24
20.if the study were written in Swedish and English words had to be translated. Ins. 24
21.many situations, such translation would be extremely difficult, if not impossible.s. 24
Outline
1.This study is divided into nine chapters. The next two chapters deal with thes. 24
2.fundamentals of the study. Chapter 2 is written from a financial perspective, ands. 24
3.explains how derivatives work and how they, together with credit-extensions. 24
4.instruments, constitute the basic building blocks of financial instruments.s. 24
5.Furthermore, the relevance of a no-arbitrage assumption, and the way it makess. 24
6.financial engineering possible, are presented in Chapter 2.s. 24
7.Chapter 3 starts by presenting the general principles of tax arbitrages ands. 24
8.proceeds by explaining how they may challenge the Swedish income tax system.s. 24
9.Also in Chapter 3, the basics of Swedish income taxation, applicable to financials. 24
10.instruments held by non-financial companies are examined. The overall purposes. 24
11.12 of Chapter 3 is to illustrate the general structures of the income tax provisions for the types of financial instruments that are explicitly dealt with in subsequent chapters.s. 24
12.Chapter 4 establishes the Swedish income tax treatment of derivatives. The way in which derivatives are defined according to the Swedish income tax system is examined first, followed by a presentation of the income tax treatment of the payoff from derivatives. Finally, the way in which the income tax treatment of derivatives constitutes tax arbitrages is illustrated.s. 25
13.Chapter 5 presents three methods that can be used to prevent tax arbitrages related to financial instruments. These methods are relevant for the examination of the Swedish income tax treatment of composite contracts, examined in Chapter 6. A composite contract is a legally distinct contract – in substance, a combination of several stand-alone financial instruments, particularly creditextension instruments and derivatives. The primary focus of Chapter 6 is the way in which composite contracts challenge the Swedish income tax system by giving rise to several tax arbitrage opportunities.s. 25
14.Chapter 7 deals with the Swedish income tax treatment of synthetics. A synthetic is a financial position consisting of a number of legally distinct financial instruments the payoffs of which offset each other in a way that makes the net payoff equal to the payoff of another, legally distinct financial instrument. This chapter examines how synthetics challenge the Swedish income tax system by constituting tax arbitrage opportunities. Furthermore, because synthetics are contractually structured the same way as risk-hedging transactions are, the Swedish income tax treatment of risk-hedging is also examined in Chapter 7.s. 25
15.Chapter 8 illustrates that IAS 39 deals with derivatives and other financial instruments in a way that appreciates their economic substance to a greater extent than does the Swedish income tax system. Furthermore, this chapter examines whether or not this difference entails that IAS 39 provides measures that can be implemented in the Swedish income tax system to prevent the identified tax arbitrages.s. 25
16.Finally, in Chapter 9, the general findings of the study are presented, together with some concluding remarks. 13s. 25
The Economic Substance of
Derivatives
Analytical Framework
1.In Section 1.3.1, Chapter 1, I note that in order to fulfil the purpose of this study – to ascertain the extent to which the Swedish income tax system provides opportunities for tax arbitrages in relation to derivatives – it is necessary to evaluate the income tax system on the basis of the economic substance of these instruments. Therefore, the economic substance of derivatives constitutes the analytical framework of this study.s. 27
2.The economic substance of derivatives cannot be considered common knowledge among commercial lawyers, who are the principal target group of this study. As a consequence, this chapter attempts to provide a general understanding of the issue, and thereby to facilitate the accessibility of the analyses carried out throughout the study.s. 27
3.First, as a basis for the assessment of the economic substance of derivatives, Section 2.2 examines the general concepts of income and risk. This section is followed by a thorough examination of the nature and effects of derivatives; Section 2.3 defines and explains the general concept of derivatives, and Sections 2.4 and 2.5 present a thorough analysis of the two general types of derivatives – price-fixing derivatives and price-insurance derivatives. Sections 2.6 and 2.7 illustrate the way in which derivatives can be used to replicate almost any conventional financial instrument, and thus permit an economically neutral or near-neutral choice between the conventional instrument and a “synthetic” version. Finally, the general points made in this chapter are presented in Section 2.8, Conclusions.s. 27
Income and Risk
The Haig-Simons Concept of Income
1.The most widely accepted concept of income is probably the Haig-Simons definition of income. By Simons’ definition, income is said to be: 15s. 27
2.the algebraic sum of (1) the market value of rights exercised ins. 28
3.consumption and (2) the change in the value of the store of propertys. 28
4.rights between the beginning and the end of the period in question.1s. 28
5.Simons’ definition of income is actually an elaboration on a theory expressed bys. 28
6.Robert A. Haig, who stated that:s. 28
7.income is the money value of the net accretion to one’s economic powers. 28
8.between two points of time.2s. 28
9.Together, the Haig-Simons concept of income is wealth at the end of the periods. 28
10.plus consumption during the period, minus wealth at the beginning of thes. 28
11.period. As Melz puts it, Haig-Simons defines income as the utmost capacity tos. 28
12.consume without decreasing wealth below its level at the beginning of thes. 28
13.period. However, as income is not always consumed in its entirety, the concepts. 28
14.generally shows the utmost capacity to consume and invest, where an increase ins. 28
15.value that is not consumed involves a decision to let that income remains. 28
16.invested.s. 28
17.In principle, the Haig-Simons definition of income is based on thes. 28
18.perspective of an individual: it defines personal income. However, using thes. 28
19.income definition in a corporate context, the Haig-Simons’ concept of incomes. 28
20.may be defined as:s. 28
21.the amount the corporation can distribute to the owners of equity in thes. 28
22.corporation and be as well off at the end of the year as at the beginning.s. 28
23.This quote establishes the fundamental concept of income as used in this study,s. 28
24.and is generally referred to as the Haig-Simons concept of income. However, ass. 28
25.the concept is used as a basis for analyzing the Swedish income tax system, thes. 28
26.amount distributable to the shareholders of the company is prior to corporates. 28
27.income taxation.s. 28
Risk
Different kinds of Risk
1.A company’s possibility of earning income is directly dependent on how itss. 28
2.business performance corresponds to the demands of the market. Withouts. 28
3.perfect information about the future, there will always be uncertainty abouts. 28
4.16 future market demands, and therefore uncertainty about a company’s income in the future. This uncertainty is generally known as business risk or speculative risk.s. 28
5.Business risk must not be mistaken for the concept of risk used in the context of insurance. In the latter context, risk is generally defined as the possibility of a negative deviation from one’s expectations. However, business risk is not necessarily a negative deviation from one’s expectation; the deviation may be positive as well. Thus business risk is the variation of return during a certain period. Limited risk means great certainty that an unknown event, which may cause the return of an investment to deviate from one’s expectations, will not happen; and large risk means great certainty that such event will occur.s. 29
6.In this study, risk is a reference to the concept referred to as business risk. A positive deviation from one’s expectation is referred to as upside risk, and a negative deviation is referred to as downside risk. The relatively large scope of the concept of business risk is sometimes reduced by referring to the actual source of risk – foreign exchange risks, for instance, or credit risks.s. 29
Risk Premium
1.Analogous to physical energy, in a closed financial context, the amount of risk is constant. From a capital market perspective, risk cannot vanish; it can only be reallocated among the market participants. In order to reduce or avoid risk, then, a company must make someone else bear the risk to which it is exposed. The cost for reallocating the risk is generally known as risk premium. Thus risk premium is the difference in expected return between a risk-free investment and an investment that is exposed to risk.s. 29
Risk and Return
1.The Haig-Simons definition of income covers any increase in wealth – any increase in capital. Thus besides any investment return, the concept also covers increases in capital that are not a result of an investment – donations or state aid, for instance. In this study, income that is not a result of an investment in capital or manpower is referred to as windfall gains.s. 29
2.In competitive markets, the price of a capital investment is usually equal to its discounted, expected future income. Consequently, all capital investments traded on a competitive market have an expected income, which can be determined by referring to the discount rate used to establish the price of the 17s. 29
3.investment. For example, investing 100 in an exchange-traded share, the values. 30
4.of which has been established on the basis of a discount rate of 10 percent,s. 30
5.entails an expected income of 10.52 percent in one year.s. 30
6.However, the risk of the exchange-traded share entails that an unexpecteds. 30
7.event may change the probability of a share providing income. If such an events. 30
8.happens, the change in value of the share is a windfall gain or loss, as thes. 30
9.investor could not predict the event at the time of the investment.s. 30
Payoff Profiles
1.To illustrate how risk influences return on an investment, payoff profiles of thes. 30
2.investments can be used. If all risks of an investment have been eliminated, thes. 30
3.payoff from an investment is perfectly predictable, and is not affected bys. 30
4.unexpected events that would otherwise influence the value of the investment.s. 30
5.The payoff profile of such a risk-free investment is illustrated in Figure A.s. 30
6.POs. 30
A
1.Expected incomes. 30
2.Rs. 30
Figure 2.1 Payoff from a risk-free investment
1.The figure illustrates the payoff from a risk-free investment at a certain futures. 30
2.date. The payoff of the investment (PO) is independent of any unexpecteds. 30
3.change, and is therefore independent of risk (R).s. 30
4.An investment that is exposed to risk provides windfall gains or losses ifs. 30
5.unexpected events occur, changing the investment’s possibility of providings. 30
6.income. Therefore, the payoff profile of such an investment is directly related tos. 30
7.18 the risk of the investment. Furthermore, the risk of a contract, such as a financial instrument, differs between the long and the short position in the contract. In principle, if a party to a financial instrument receives a windfall gain, the counterparty to that contract receives a corresponding windfall loss. Figure B illustrates the payoff profile of a short position in a financial instrument exposed to risk, and Figure C illustrates the payoff profile of a long position in a financial instrument exposed to risk.s. 30
8.PO POs. 31
B C
1.R Rs. 31
Figure 2.2 Payoff profiles relating to unexpected change
1.Payoff profiles relating the payoff (PO) from a position in a financial instrument to unexpected changes in the value of the financial instrument – to risk (R). In summary, expected income is the return provided by an investment, presupposing that it is not subject to any unexpected events that change its potential to provide future income. Thus an investment provides expected income if the risks connected to the investment are eliminated. A windfall gain or loss is the difference between expected income and the total income of an investment. When an investment provides a windfall gain or loss, it is because of unexpected events that change the investment’s potential to provide income. More specifically, windfall gains or losses arise as a result of the risk to which an investment is exposed. 19s. 31
Derivatives
Definition
Derivative
1.A derivative is generally defined as: “A financial instrument, the price of whichs. 32
2.has a strong relationship with an underlying commodity, currency, economics. 32
3.variable, or financial instrument.” It follows from the derivative definition thats. 32
4.the value of a derivative is determined on the basis of the value of somethings. 32
5.else – on the basis of an underlying. Derivatives are distinguished from regulars. 32
6.spot transactions in that derivatives are settled at a future date. When decidings. 32
7.the value of a derivative, it is necessary to consider not only the price of itss. 32
8.underlying, but also the time value left until maturity of the contract.s. 32
9.However, these characteristics also apply to commercial contracts that ares. 32
10.not usually known as derivatives. For instance, the delivery price in regulars. 32
11.purchase or sales contracts is usually established with reference to the value ofs. 32
12.the underlying of the contracts and the time left to delivery. To exclude regulars. 32
13.purchase or sales contracts from a derivative definition, derivatives are generallys. 32
14.defined as financial instruments. Consequently, the derivative definition iss. 32
15.eventually dependent on the contents of the term, “financial instrument”.s. 32
Financial Instrument
1.In principle, the meaning of the term, “financial instrument”, differs dependings. 32
2.on the context in which it is used. In its broadest sense, a financial instruments. 32
3.can be defined as:s. 32
4.…any evidence of the legal relationship arising from the provision ofs. 32
5.money, property, or a promise to pay money or property by one person tos. 32
6.another in consideration for a promise by the other person to provides. 32
7.money or property at some future time or times, or upon the occurrences. 32
8.or non-occurrence of some future event or events.s. 32
9.This broad definition of financial instrument more or less covers all commercials. 32
10.contracts, specifically transferable contracts that bear their own independents. 32
11.value. However, the broad definition of financial instrument may be reduced.s. 32
12.For example, in the context of International Financial Reporting Standards,s. 32
13.IFRS, a financial instrument is: “…any contract that gives rise to a financials. 32
14.20 asset of one entity and a financial liability or equity instrument of another entity.”s. 32
15.The principle difference between the two definitions of financial instrument is that the latter excludes contracts that pay property other than cash or financial securities. A delivery contract on grain is included in the broad definition of a financial instrument, for example; whereas it is outside the scope of the narrower definition. Therefore, the contents of the derivative definition may be fundamentally different, depending on the meaning employed for the term, “financial instrument”.s. 33
Derivatives and other Financial Instruments
1.This study focuses on the income tax treatment of derivatives that challenge the Swedish income tax system. In principle, derivatives that entail delivery of assets other than financial securities do not cause problems to the income tax system. Consequently, this study generally deals with derivatives that are financial instruments in a relatively narrow sense. Consequently the term “financial instrument” has a narrow meaning in this study, and the term “derivative” refers to a derivative that is a financial instrument.s. 33
Derivative Trade
1.In Sweden, organized trade with derivatives, involving, for instance, options and futures, has existed for a little more than twenty years. From a global perspective, however, derivative contracts are not new; they have probably been used in commercial transactions for thousands of years. History shows that derivatives have often existed in connection with commodity hedging or speculation. In order to even out the flow of seasonal commodities, such as grain or corn, delivery contracts known as “to-arrive” contracts have been used. Initially, to-arrive contracts were viewed as commercial contracts, but today they are better known as future contracts, which are tradable independent of the underlying commodity. In parallel with the trade of commodities, an independent trade of derivatives could often be seen to occur at the public commodity markets.s. 33
2.In general, there are two kinds of marketplaces for derivative trade: exchange-traded markets and over-the-counter markets. Derivative exchanges are marketplaces where standardized derivative contracts, which have been 21s. 33
3.defined by the exchanges, are traded. The world’s largest derivative exchangess. 34
4.are Eurex; the Korean exchange, KRX; Chicago Mercantile Exchange, CME;s. 34
5.and the Chicago Board of Trade, CBOT.s. 34
6.The over-the-counter (OTC) market is one in which dealers are free tos. 34
7.negotiate their derivative contracts as they like. Trade is often conducteds. 34
8.between financial institutions or between a financial institution and a client. Thes. 34
9.OTC markets have no formal organization; however, traders usually conducts. 34
10.their transactions in accordance with regulations established by professionals. 34
11.market associations. An example of such an organization is Internationals. 34
12.Swaps and Derivatives Association Inc. (ISDA), which has developed the ISDAs. 34
13.Master Agreement that applies to derivative contracts traded on the OTCs. 34
14.market. Thus although the exchange traded derivative markets are individuallys. 34
15.regulated by the derivative regulation of each individual exchange, thes. 34
16.regulation of the OTC derivative market is usually founded on thes. 34
17.documentation of various professional market associations.s. 34
18.Today the global trade in derivatives is enormous. The notional principles. 34
19.amount of outstanding OTC derivatives totalled USD 415,183 billion at the ends. 34
20.of December 2006. The total gross market value of these contracts was USDs. 34
21.9,695 billion. The OTC derivative market is estimated to be approximately fives. 34
22.times the USD value of the exchange traded derivative market. Using thats. 34
23.factor, it is possible to conclude that the total gross market value of outstandings. 34
24.derivatives at the end of December 2006 was roughly USD 11.6 billion.s. 34
The Purpose of Derivative Trade
1.According to Hull, there are usually three reasons to enter a derivative contract:s. 34
2.hedging, speculation, and arbitrage. Hudson adds another reason –s. 34
3.asset/liability management – however this addition involves many of thes. 34
4.characteristics of hedging and speculation, so will not be considered ans. 34
5.independent purpose. According to Board, derivatives can sometimes bes. 34
6.effectively used to exploit loopholes in the regulations. This type of regulatorys. 34
7.evasion includes regulatory arbitrage and tax arbitrage, issues that ares. 34
8.thoroughly discussed in Section 3.2, Chapter 3. Finally, in recent decades,s. 34
9.derivatives have been used in incentive programs, such as employee stocks. 34
10.22 options schemes. However, from a company’s perspective, these incentive schemes are part of the company’s asset/liability management, and would therefore be considered to be covered by the reason proposed by Hudson. Consequently, besides using derivatives for the purpose of exploiting loopholes in regulation, the general reasons for derivative trade are those set out by Hull: hedging, speculation, and arbitrage.s. 34
11.Hedgers, speculators, and arbitrageurs use derivatives for their qualities of transferring risk. Basically there are two ways a derivative can be used to transfer risk: to fix the future price of the underlying of the derivative or to insure a future price by providing the holder of the derivative the possibility (option) of selling or acquiring the underlying at a certain price in the future. Therefore, all basic derivatives can be divided into these groups, which, in the following discussion, are referred to as price-fixing derivatives and priceinsurance derivatives.s. 35
Price-Fixing Derivatives
Forwards
Definition
1.A forward contract is an agreement to purchase or sell an underlying at a certain price on a certain future date. The underlying does not have to be a physical asset, but could as well be an index or interest rate, for example. The party that has agreed to purchase the underlying is said to be in a long position of the contract and the party who is obliged to sell the underlying in a short position in the forward contract.s. 35
2.Most derivative exchanges offer a large variety of standardized forwards. A standardized forward contract specifies that the underlying and the date of maturity are non-negotiable. Non-standardized forwards are negotiated on the OTC market.s. 35
The Delivery Price of a Forward
1.When a forward contract is negotiated, its delivery price is usually set equal to the future price of the underlying,a step taken to cover the cost of financing the underlying during the lifetime of the forward. Furthermore, if the underlying 23s. 35
2.provides known income or expenses during the lifetime of the forward –s. 36
3.dividends and/or storage costs, for example – the future value of that incomes. 36
4.and/or expense is considered when the delivery price of the derivative iss. 36
5.established. The value of the additional expenses and income is usuallys. 36
6.summarized in terms of cost of carry. Consequently, the difference betweens. 36
7.the delivery price of a forward and the spot price of the underlying is the cost ofs. 36
8.carry for the underlying.s. 36
9.If the underlying of a forward entails no income, or storage costs – fors. 36
10.instance, in case of a no-dividend paying share – the cost of carrying thes. 36
11.underlying equals the (hypothetical) interest that is paid to finance it. Thus thes. 36
12.cost of carry for the underlying of a forward contract always entails the interests. 36
13.expense of the capital of the underlying.s. 36
14.When pricing derivatives, such as forwards, the hypothetical interest expenses. 36
15.is established on the basis of a risk-free interest rate. The risk-free interest rate iss. 36
16.usually known as the rate at which money can be borrowed or loaned with nos. 36
17.credit risk. When pricing derivatives, the risk-free interest rate typically used iss. 36
18.the London Interbank Offered Rate (LIBOR). When establishing the price ofs. 36
19.derivatives, interest rates are measured on the basis of continuouss. 36
20.compounding. The difference between continuous compounding and annuals. 36
21.compounding is shown in the following example:s. 36
22.Example:s. 36
23.If the interest rate is 10 per cent and the principle amount is 100, ans. 36
24.annual compounding would entail that the value of the principle amounts. 36
25.at the end of the year would be 110 (100 * (1 + 0.1)). If thes. 36
26.compounding were done on a daily basis, the principle amount at thes. 36
27.end of the year would be 110.52 (100 * (1+0.1/365)^365). Withs. 36
28.continuous compounding, the value of the principle amount would alsos. 36
29.have been 110.52 (110e^0.1); therefore, continuous compounding can bes. 36
30.seen as the interest being compounded on a daily basis.s. 36
31.To summarize, the delivery price of a forward contract equals the present values. 36
32.of the underlying capitalized to maturity of the contract with a risk-free interests. 36
33.rate. Furthermore, because the exercise price of the forward contracts. 36
34.compensates for the cost of carry, the market value of the contract is zero at thes. 36
35.time of negotiation.s. 36
36.24s. 36
The Value of a Forward
1.It is only at the date of negotiation of a forward contract that the contract has no value. Changes in the spot price of the underlying, the risk-free interest rate, and the time left to maturity influence the value of the contract.s. 37
2.Assuming that there are no changes in the risk-free interest rate, a long forward contract can be valued by subtracting the delivery price of the forward from the spot price of the underlying. This can be explained based on the fact that if the spot price is higher than the delivery price, the holder of a long forward can exercise the contract, sell the underlying on the spot market, and still have some money left over. However, as the delivery price of the forward is a capitalization of the value of the underlying at the time the contract was negotiated, it must be discounted to its present value. Consequently, the value of a long forward contract can be expressed in the following way: (2.1) long forward contract = S – De, where S is the spot price of the underlying, D is the delivery price of the forward contract, T is time left to maturity, and r is the risk-free interest rate.s. 37
3.Similarly, a short forward contract can be valued by subtracting the spot price of the underlying from the delivery price of the forward contract. If the delivery price is greater than the spot price of the underlying, then, the party in a short position can exercise the contract to sell the underlying; buy a new, equal underlying on the spot market; and still have some money left. Consequently, the value of a short forward contract can be expressed in the following way: (2.2) short forward contract = De – S. However, it is important to remember that forward contracts, like all price-fixing derivatives, cannot be exercised until maturity. Therefore, these examples can be seen as principle illustrations of how price-fixing derivatives are valued before maturity, as in connection with a closing-out transaction, for example. Furthermore, the examples presuppose that the underlying is an investment asset and not a consumption asset. If the underlying were a consumption asset, it is possible that the holder of the asset would be reluctant to sell the asset and buy a forward (as in the examples above) because the asset has an additional value compared to the forward, in that it can be used in the production of the company. 25s. 37
Futures
1.The functions and principles for valuation of futures contracts are generally thes. 38
2.same as for forward contracts, but unlike forward contracts, futures are subjects. 38
3.to daily settlement. The daily settlement of the fluctuation between the spots. 38
4.price and delivery price of a futures contract reduces the default risk connecteds. 38
5.with the contract. Thus a futures contract can be seen as a number of forwards. 38
6.contracts, in which one contract is settled every day. Another importants. 38
7.difference between forwards and futures is that futures contracts are alwayss. 38
8.highly standardized and may be traded anytime before maturity.s. 38
9.The daily settlement of futures contracts makes their payoff profile slightlys. 38
10.different from the payoff profile of a forward contract. This is primarily becauses. 38
11.the daily settlements make positive payoff from a futures contract available fors. 38
12.additional investment before the maturity of the contract. Likewise, a negatives. 38
13.payoff from a futures contract limits the possibilities of making additionals. 38
14.investment before maturity. However, as the lifetime of a futures contracts. 38
15.decreases, the differences between forward and futures contracts become smallers. 38
16.and smaller. Consequently, futures contracts with a relative short lifetime haves. 38
17.a payoff profile almost identical to forward contracts.s. 38
Swaps
1.A swap contract is an agreement to purchase or sell an underlying at a certains. 38
2.time at a certain price. Thus technically, there are no differences betweens. 38
3.forwards and swaps. What distinguishes the two types of contract is that swaps. 38
4.contracts usually involve several settlements before maturity, whereas forwardss. 38
5.are settled only at the date of maturity. Like forwards, swap contracts can haves. 38
6.a lifetime of several years, but swaps involve settlements on a regular basis,s. 38
7.usually annually or semiannually, a feature that decreases their default risks.s. 38
8.Swaps are traded on the OTC market, and the most common swap contractss. 38
9.are interest rate swaps: swap contracts with interest as the underlying. As. 38
10.typical interest rate swap involves two parties holding debt with floating ands. 38
11.fixed interest rate respectively. The swap requires one party to pay the others. 38
12.party’s interest over a specified period, and vice versa. Such arrangements cans. 38
13.be viewed as the parties buying the conditions of each other’s loan at a prices. 38
14.corresponding to the interest of their respective loans, that is, they swap floatings. 38
15.interest rate for a fixed interest rate, and vice versa. The settlements are typicallys. 38
16.netted, meaning that the party that has had the greatest payoff during the periods. 38
17.receives the difference between that payoff and the payoff owed thes. 38
18.counterparty of the contract.s. 38
19.26s. 38
Using Price-Fixing Derivatives to Transfer Risk
1.The way in which the delivery price of a forward or any other price-fixing derivatives is established, requires that, from the day a party enters into a short forward contract on an asset in its possession, the net payoff of the asset and the derivative equals the return of a risk-free investment. Consequently, the short position in a forward transfers the total risk of the underlying to the party in a long position of a forward. Thus if the value of the underlying unexpectedly changes, the value of a long forward position will change in the same direction. It follows that any windfall gains or losses which would have been attributable to the holder of the underlying and the short forward, are, in principle, transferred from that party to the party in the long position of the forward. However, it is important to note that if the party in a short position in a forward is not in possession of the underlying asset of the forward, it is exposed to a risk opposite to that of the underlying asset. Thus if the value of the underlying asset increases, the value of the short forward decreases, and vice versa.s. 39
2.The way in which a price-fixing derivative, like a forward, transfers the entire risk of its underlying can be illustrated by means of its payoff profile. When a price-fixing derivative is exercised, its payoff is the difference between the delivery price of the contract and the spot price of its underlying. The cost of carry is relevant only when the derivative is closed out before maturity. Therefore, disregarding the cost of carry, the payoff of a long forward is the spot price of its underlying at maturity (S) minus the delivery price (D), and the payoff from a short forward is D-S. Thus the payoff profiles of forward contracts may be illustrated in the following way: 27s. 39
3.Payoff Payoffs. 40
B
A
1.S Ss. 40
2.D Ds. 40
Figure 2.3 Payoff from a forward contract
1.Figure A shows the payoff from a long position in a forward contract, ands. 40
2.Figure B the payoff from a short position in a forward contract, where S is thes. 40
3.spot price of the underlying at delivery and D (in the origin of coordinates) iss. 40
4.the agreed delivery price.s. 40
5.As noted in this section, when a price-fixing derivative is used to transfer aways. 40
6.the entire risk of an asset, the net payoff of the asset and the derivative is equals. 40
7.to a risk-free investment. Purchasing an asset and simultaneously entering into as. 40
8.short forward on that asset would give a payoff equal to an investment in, fors. 40
9.instance, a government bond.s. 40
10.28 PO SF A EI Ds. 40
11.SPs. 41
Figure 2.4 How a forward offsets the risk to which an asset is exposed
1.The figure shows how the short forward offsets the risks to which an asset is exposed, providing a net income that is perfectly predictable. D is the delivery price of the short forward and SF and A are the payoff profiles of the short forward and the asset, respectively. SP is the spot price of the asset and PO is the payoff of the investments. EI is expected income, which is equal to a riskfree investment independent of the variations in the spot price of the asset.s. 41
Price-Insurance Derivatives
Options
The Function of Options
1.Price-insurance derivatives are generally known as options. An option is a contract that gives one party the possibility of purchasing or selling a specified underlying at a certain price at a specified future time. The other party of the contract is obliged to sell or to purchase the underlying if the counterparty exercises its option. The party holding a price-insurance derivative is insured that it will not suffer from unexpected events, making the price of the underlying less favorable than the strike price stated in the contract. However, if unexpected events make the price of the underlying more favorable than the strike price of the option, the holder of the derivative may chose not to exercise it, thereby 29s. 41
2.benefiting from these changes – a benefit that would not have been available tos. 42
3.the holder of a price-fixing derivative. In cases in which an option is exercised,s. 42
4.the issuer of the derivative will suffer from the unexpected changes in the prices. 42
5.of the underlying, as that party has to purchase or sell the underlying at a prices. 42
6.that is less favorable than the price on the spot market.s. 42
Different Kinds of Options
1.An option contract always gives the holder the right to exercise the contract at as. 42
2.certain time. Options that let the holder exercise its right any time up to thes. 42
3.expiration date are called American options, and options that can only bes. 42
4.exercised on a specific date are called European options. Most of the optionss. 42
5.traded on exchanges are American. Options that are not traded on an exchange,s. 42
6.and thus differ from the standardized options in one way or the other, are oftens. 42
7.referred to as exotic options.s. 42
8.Whether options are American, European, or exotic, they are always divideds. 42
9.into call options and put options. The holder of a call option has a right tos. 42
10.purchase the underlying and the counterparty is thus obliged to sell thes. 42
11.underlying if the holder chose to exercise its right. A put option is a contract thats. 42
12.gives the holder a right to sell the underlying and the counterparty has ans. 42
13.obligation to purchase the underlying if the contract is exercised. Consequently,s. 42
14.there are four contractual positions in option contracts: a long position in a calls. 42
15.option, a short position in a call option, a long position in a put option, and as. 42
16.short position in a put option.s. 42
Intrinsic Value and Time Value
1.Just like any other kind of derivatives, the value of an option is directlys. 42
2.dependent on the value of its underlying and the time left to maturity of thes. 42
3.contract. The value that an option derives from the value of its underlying iss. 42
4.called its intrinsic value, defined as the difference between the exercise price ofs. 42
5.the option and the spot price of the underlying. Thus intrinsic value is the values. 42
6.the derivative would have if it were exercised immediately.s. 42
7.The intrinsic value of an option can be decided with high reliability, as longs. 42
8.as there is a liquid market for the derivative and/or the underlying. Therefore,s. 42
9.the intrinsic value of exchange traded options is a relatively uncomplicateds. 42
10.issue. However, the liquidity for options that are not traded on exchanges – OTCs. 42
11.options – is as high as it is for underlyings of these options. Thus the valuations. 42
12.of OTC options may cause great concerns, as it may be difficult to decide thes. 42
13.value of underlyings.s. 42
14.In addition to their intrinsic value, options also have a time value. The times. 42
15.value is the worth of the possibilities for favorable movements in the intrinsics. 42
16.value of the option. With time left until maturity of the option, there is alwayss. 42
17.30 a possibility that the price of the underlying will develop in a way that positively affects the value of the option. Thus the time value is the difference between the intrinsic value and the total value of the option.s. 42
The Strike Price of an Option
1.Unlike the delivery price of a forward contract, the strike price of an option is not a capitalization of the present value of the underlying. Instead, the strike price is set to meet the requirements of the buyer of the option (in the OTC market) or to correspond with the regulations for the exchange where these options are traded. The value of an option is, in principle, never zero; an option always has a value. This value is either a time value only or it is the sum of time value and intrinsic value. Thus unlike price-fixing derivatives, price-insurance derivatives have a market value (price) at the date of issue. Therefore, the party in the short position of the contract is rewarded a premium corresponding to the value of the issued option.s. 43
The Value of an Option
1.The characteristic of an option that distinguishes it from a price-fixing derivative is that the holder of an option may choose not to exercise it. This means that the possible negative payoff of a long position in an option is limited to the price (premium) of the option, whereas the positive payoff of the position is unlimited.s. 43
2.The attributes of the underlying of an option are vital for its valuation. For example, high volatility in the price of the underlying increases the value of the option because positive changes in the underlying always fully affect the value of the option, whereas a negative movement in the underlying has only a limited influence on the value of the option. In a forward contract, in which the parties are obliged to exercise the contract, the volatility of the underlying would not affect the value of the forward, as the possibilities of positive or negative movements in the value of the underlying would offset each other.s. 43
3.Furthermore the terms applicable to deciding the right to exercise an option also affect the value of the option. Compared to a holder of a European option, the holder of an American option has an additional right: the right to early exercise. Thus the value of an American option will always be the same or greater than a corresponding European option. The value will be greater if it is more profitable to exercise the option before maturity. However, it is difficult to identify cases in which an early exercise of an option is more favorable than an exercise at maturity, making the valuation of an American option relatively complex. 31s. 43
4.Like any kind of valuation, the valuation of options entails elements ofs. 44
5.subjectivity, which makes it a rather complicated exercise. Among the attemptss. 44
6.that have been made to establish a conventional option-pricing model, the mosts. 44
7.well known is the Black-Scholes Option-Pricing Model. This model wass. 44
8.developed at the beginning of the 1970s, and its founders were awarded thes. 44
9.Nobel Prize in 1997. However, the Black-Scholes Option-Pricing Model ands. 44
10.other valuation models for options will not be further analyzed in this study, ass. 44
11.such analysis would not contribute to our main purpose. Instead, the rest of thiss. 44
12.section focuses on the fundamental principles for option pricing, as theses. 44
13.principles are used to explain how options transfer risk. For simplicity, the rests. 44
14.of this chapter, unless otherwise stated, refers to European options that haves. 44
15.highly liquid underlyings.s. 44
Long positions in Options
1.As noted in Section 2.5.1.1, the principle difference between an option and as. 44
2.forward contract is that the holder of an option may choose not to exercise thes. 44
3.contract, a possibility that the holder of a forward contract lacks. Consequently,s. 44
4.the value of an option is never lower than the value of a corresponding forwards. 44
5.contract, but the value may be higher because the lower limit of the value of ans. 44
6.option is the paid premium. Thus the value of a call option is the greater of thes. 44
7.paid premium, which is negative, and the value of a long position in as. 44
8.corresponding forward contract. This is generally expressed as:s. 44
(2.3) max (S – Pe; paid premium)
1.where S is the spot price of the underlying and P is the strike price of the options. 44
2.contract, T is time left to maturity, and r is the risk-free interest rate.s. 44
3.Another way to explain how to value a long call option is to emphasize thes. 44
4.fact that, with a no-arbitrage assumption, a portfolio with a long call option ands. 44
5.a bond that has a principle amount equal to the present value of the strike prices. 44
6.of the option, is always worth as much as or more than the underlying of thes. 44
7.option. This valuation occurs because, if the price of the underlying at maturitys. 44
8.of the option is greater than the strike price of the option, the holder of thes. 44
9.option can sell the bond, thereby obtaining enough money to exercise the options. 44
10.to buy the underlying. In this situation, the two portfolios are of equal worth. Ifs. 44
11.the price of the underlying at maturity of the option contract is lower than thes. 44
12.exercise price, the holder of the option can sell the bond and buy the underlyings. 44
13.on the spot market. In this situation, the value of the portfolio with the bond ands. 44
14.the option is of greater worth than the portfolio with the underlying, because thes. 44
15.bond has a higher market value than the underlying. Consequently, the value ofs. 44
16.a long call option can be explained as:s. 44
17.32s. 44
(2.4) LC + Pe > S => LC > S – Pe
1.where LC is a long call option, S is the spot price of the underlying, P is the strike price of the option contract, T is time left to maturity, and r is the risk-free interest rate. Because a long call option will not be exercised if the spot price of its underlying is lower than its strike price, the value of the option will never falls. 45
below the premium paid for it. Consequently:
1.(2.5) LC > max (S – Pe, paid premium). Just as a call option is similar to a long position in a forward contract, a put option is similar to a short position in a forward contract. However, the option to sell the underlying will not be exercised if the spot price of the underlying is greater than the strike price of the option. Consequently, for the same reason as is the case for a long call option, the value of a long put option (LP) can be expressed as: (2.6) LP > max (Pe-S, paid premium).s. 45
Put-Call Parity
1.As argued in the previous section, the value of a portfolio with one long call option and a bond equal to the present value of the exercise price of the option, is always equal to or greater than the value of a portfolio with the underlying (LC + Pe > S). Similarly, the value of a portfolio with one long put option and the underlying is always the same or greater than the value of a portfolio with a bond equal to the present value of the strike price of the option (LP + S > Pe ). Consequently, the portfolios with options are worth the greater of the spot price of the underlying and the strike price of the option. Therefore, if the options have corresponding terms – the same underlying, the same strike price, and the same duration – the value of the two portfolios are identical. Thiss. 45
relationship can be expressed as:
(2.7) LC + Pe = LP + S
1.and is known as put-call parity. Put-call parity requires that the value of a long call option be established on the basis of the value of a corresponding long put option, and vice versa.s. 45
Short Positions in Options
1.A short position in an option contract has exactly the opposite value compared with the long position of the contract. It involves no option, but an obligation to fulfill the contract if its holder so wishes. Therefore, if the spot price of the underlying is greater than the strike price of a call option, the party having a short position in that option is, in principle, obliged to sell the underlying at the 33s. 45
2.strike price of the option. On the other hand, if the spot price of the underlying iss. 46
3.lower than the strike price of a call option, the party having a long position ins. 46
4.the option will not exercise it, but will purchase the underlying on the spots. 46
5.market. The party having a short position in the option will then benefit froms. 46
6.keeping the premium received when the option was issued. Consequently, thes. 46
7.positive value of a short position of an option is limited to the value of thes. 46
8.premium, whereas the negative value of such position is unlimited.s. 46
9.As the value of a short position of an option is opposite that of the value of as. 46
10.long position of the option, the value of a short call option can be expressed as:s. 46
(2.8) - max (S-Pe; received premium)
1.ors. 46
(2.9) min (Pe-S; received premium)
1.Similarly, the value of a short position in a put option can be expressed as:s. 46
(2.10) min (S-Pe; received premium)
The Payoff from Options
1.The payoff from an option equals the intrinsic value of the option whens. 46
2.exercised. Therefore, unlike the value of an option, the payoff from an options. 46
3.is established without regard to a time value. Thus disregarding the time value,s. 46
4.the payoff from a long call option iss. 46
(2.11) max (S-P; paid premium)
1.where S is the spot price of the underlying and P is the strike price of the option.s. 46
2.Likewise, the payoff from a short call option iss. 46
(2.12) min (P-S; received premium)
1.the value of a long put option iss. 46
(2.13) max (P-S; paid premium)
1.and the value of a short put option iss. 46
(2.14) min (S-P; received premium)
1.The four different payoff profiles are illustrated in the following diagrams:s. 46
2.34s. 46
3.Lo ng Call Option: max (S-P; pp) Short Call Option: min (P-S; rp)s. 47
4.PO PO P S S Ps. 47
5.Long Put Option: max (P-S; pp) Short Put Option: min (S-P; rp)s. 47
6.PO POs. 47
7.P S Ss. 47
8.Ps. 47
Figure 2.5 The four payoff profiles of options
1.PO is the payoff from the option, S is the spot price of the underlying, P (in the origin of coordinates) is the strike price of the option, pp is paid premium, and rp is received premium. The horizontal line in the payoff profile indicates the value of the premium of the option.s. 47
Using Price-Insurance Derivatives to Transfer Risk
Upside Risk
1.As is illustrated in Section 2.5.1.2, a long position in a call option is a right to purchase the underlying of the option at a fixed price in the future. Any unexpected change in the value of the underlying will influence the value of the 35s. 47
2.option. However, if the unexpected change in the underlying means that thes. 48
3.value of the asset, and thus the option, will decrease, the holder of the call options. 48
4.may chose not to exercise it. Thus the payoff from a long position in a calls. 48
5.option equals the increase in value of the underlying asset resulting froms. 48
6.unexpected events. In comparison with a long forward, a long call option iss. 48
7.exposed only to the upside risk of the underlying asset, whereas the forward iss. 48
8.exposed the total risk of the underlying asset. Consequently, a call option cans. 48
9.be considered as a contract that transfers the upside risk of the underlying assets. 48
10.from the party in a short position to the party in a long position of the option. As. 48
11.party in a short position of a call option is thus exposed to a risk that is thes. 48
12.reverse to the upside risk of the underlying asset; the value of the positions. 48
13.decreases if the value of the underlying asset increases.s. 48
Downside Risk
1.The downside risk of the underlying asset is the same as the risk of a shorts. 48
2.position in a put option because a short put option generally involves ans. 48
3.obligation to purchase the underlying asset if the holder of the option so wishes.s. 48
4.The put option will be exercised if the strike price of the option is greater thans. 48
5.the spot price of the underlying. As a result, the put option will be exercised ifs. 48
6.the value of the underlying unexpectedly falls and the decrease in value will thuss. 48
7.eventually hit the party having a short position in a put option on the underlying.s. 48
8.Therefore, the party having a long position in a put option is exposed to a risks. 48
9.that is the reverse of the downside risk of the underlying. In other words, thes. 48
10.value of the long position will increase if the value of the underlying decreases.s. 48
11.Consequently, a long position in a put option may be used to transfer thes. 48
12.downside risk of an asset from one party to another.s. 48
Total Risk
1.A call option is a derivative that transfers the upside risk of its underlying froms. 48
2.the party in a short position of the contract to the party in a long position. A puts. 48
3.option is a derivative that transfers the downside risk of the underlying assets. 48
4.from the party in a long position of the contract to the party in a short position.s. 48
5.Consequently, by simultaneously taking a long position in a call option and as. 48
6.short position in a put option, it is possible to achieve the total risk exposure ofs. 48
7.the underlying asset. Therefore, the payoff from such a portfolio equals thes. 48
8.payoff of a long forward contract. Likewise, by taking a long position in a puts. 48
9.option and simultaneously taking a short position in a call option, it is possibles. 48
10.to obtain the same risk exposure as a position in a short forward contract.s. 48
11.To summarize, different positions in options can be used to transfer the upsides. 48
12.risk, the downside risk, or the total risk of an underlying. In that way, optionss. 48
13.are more flexible than price-fixing derivatives, when it comes to risks. 48
14.management.s. 48
15.36s. 48
Financial Engineering
No-arbitrage
The Modigliani-Miller Proposition
1.Financial engineering is about combining or dividing different financial instruments in order to achieve a required financial position. In this study, the basic principles of financial engineering will be used to illustrate how financial instruments that challenge the Swedish income tax system are created.s. 49
2.Fundamental to financial engineering is the no-arbitrage assumption. In the finance literature, this assumption is generally said to originate from the classic work of Modigliani and Miller (MM). MM showed that if the market value of two companies whose only difference is their financial policy is not equal, pricing arbitrage would exist. Consequently, on a capital market in equilibrium, there are no differences in price between two such companies. MM underlines this point by a famous analogy:s. 49
3.…under perfect markets, a dairy farmer cannot in general earn more fors. 49
4.the milk he produces by skimming some of the butter fat and selling its. 49
5.separately, even though butter fat per unit weight, sells for more thans. 49
6.whole milk. […] … the price per gallon of thinned milk falls continuouslys. 49
7.as more butter fat is skimmed off. The point made in the analogy is that the price of one gallon of whole milk is the same, no matter whether it is presented as whole milk or as thinned milk and butter fat. Similarly, on the basis of the MM theorem, it is possible to conclude that, on a capital market in equilibrium, the price of a financial instrument (A) that is in substance a combination of the financial instruments (B) and (C), equals the total price of the two separate instruments (B) and (C). Therefore, a no-arbitrage assumption entails that financial positions with the same economic substance are of equal worth.s. 49
8.Besides the presumption of a capital market in equilibrium, the no-arbitrage assumption requires an environment with no transaction costs, no taxes, no information asymmetry, and no bankruptcy costs. Consequently, the assumption does not mirror the financial market as it works in reality. However, as the assumption explains the economic relationships between various financial 37s. 49
9.positions independent of taxes, it is well suited for use in an analysis concernings. 50
10.the effect of tax rules when applied to these economic positions.s. 50
Pricing Derivatives
1.The reasoning in Sections 2.4 and 2.5 on price-fixing and price-insurances. 50
2.derivatives is based on a no-arbitrage assumption. For example, the conceptions. 50
3.that a long position in a forward contract is exposed to the total risk of itss. 50
4.underlying is correct only under a no-arbitrage assumption. Similarly, withouts. 50
5.a no-arbitrage assumption, it is not possible to conclude that a long call options. 50
6.and a short put option equal the position of a long forward contract.s. 50
7.Consequently, as a basis for the previous argument, it has been necessary tos. 50
8.presume that all transactions are carried out in a non-arbitrage environment – ons. 50
9.a capital market in equilibrium.s. 50
10.The use of the no-arbitrage assumption is in line with the general principless. 50
11.of derivative pricing. This study does not analyze the actual pricing ofs. 50
12.derivatives. However, to facilitate the understanding of how derivatives ares. 50
13.used to transfer risk, some fundamental concepts concerning the pricing ofs. 50
14.derivatives are presented. The basis for these concepts is that derivatives ares. 50
15.used to replicate a financial position of a contractually different financials. 50
16.instrument. In that way, the value of the derivative can be derived from the values. 50
17.of the replicated position, a value that, in many situations, is relatively easy tos. 50
18.establish.s. 50
The Relationship Between Spot Prices and Forward Prices
1.In Section 2.4.1.2 it is argued that the exercise price of a forward is the spots. 50
2.price plus remuneration equal to the cost of carry of the underlying. By settings. 50
3.the cost of carry equal to the interest expense of a risk-free bond, it is possible tos. 50
4.establish the value of a forward position with reference to the spot price of itss. 50
5.underlying, and a risk-free bond with a principle amount equal to the presents. 50
value of the delivery price of the forward:
(2.15) long forward contract = S-De
1.ands. 50
2.(2.16) short forward contract = De-S.s. 50
3.The validity of the relationship between spot prices and forward prices can bes. 50
4.illustrated by a number of examples. First, let us assume that the one-years. 50
5.38 forward price of an asset with a spot price of 100 is 110.52 if the risk-free interest rate is 10 percent. If the forward price were to be set to something other than 110.52 (e.g. 105.52), an arbitrageur could make a risk-free gain of 5 by taking a long position in a forward, short-selling the underlying and investing the money in a risk-free one-year bond. At the end of the year, the arbitrageur would receive 110.52 from the risk-free investment in the bond, would use 105.52 to purchase and return the underlying, and would still have 5 left. Similarly, if the forward price was set at, for example, 115.52, an arbitrageur would make the risk-free profit of 5 by taking a short position in a forward and issuing a (risk-free) bond of 100 to purchase the underlying. At the end of the year, the arbitrageur would exercise the forward to sell the asset at the price of 115.52, use 110.52 to return the principle amount of the bond plus accrued interest, and still have 5 left.s. 50
6.To summarize, on the basis of a no-arbitrage assumption, it is possible to establish the value of a forward with reference to the spot price of its underlying and a risk-free bond. Because, in most cases, it is relatively uncomplicated to establish the values of these securities, the valuation of forwards is also relatively straightforward.s. 51
Interest-Rate Parity
1.The relationship between spot prices and forward prices is evident in the case of currency. The interest rate parity entails that the difference between the spot price and the forward exchange rate of two currencies equals the difference between the interest rates in the same currencies. If this were not the case, and the interest rate in foreign currency was proportionally greater, an arbitrageur could make a risk-free profit simply by investing in a foreign bond and similarly taking a long position in a forward contract on the principle amount of the bond. Consequently, the no-arbitrage assumption entails that the spot foreign exchange rate, the forward foreign exchange rate, and the credit market prices must be mutually consistent.s. 51
2.In a similar way, because the forward exchange rates of currencies are established to eliminate pricing arbitrage possibilities, forward interest rates are functions that hamper pricing arbitrages. For example, if the net payoff of the one-year forward interest rate and the one-year spot interest rate does not equal the payoff from the two-year spot interest rate, arbitrage opportunities would occur. 39s. 51
Put-Call Parity (revisited)
1.In Section 2.5.1.7, put-call parity was described as a principle for option pricing.s. 52
2.However, the same principle is useful to illustrate the fundamentals of financials. 52
3.engineering and is therefore revisited in this section.s. 52
4.In Section 2.2.2.4, it is noted that a risk-free investment provides expecteds. 52
5.income, and an investment that provides income only if something unexpecteds. 52
6.happens provides windfall gains or losses. On the basis of this division ofs. 52
7.income, it is possible to argue that the payoff from a portfolio involving a longs. 52
8.position in a call option and a long position in a risk-free, discounted debts. 52
9.instrument is partly expected income and, possibly, windfall gains. Thiss. 52
10.portfolio is not exposed to the downside risk of the underlying of the option.s. 52
11.Similarly, the payoff of a portfolio involving a long position in a put options. 52
12.and a long position in the underlying (asset) of the option comprises partlys. 52
13.expected income and, possibly, windfall gains. As in the situation described ins. 52
14.the previous paragraph, this portfolio is not exposed to the downside risk of thes. 52
15.underlying.s. 52
16.The financial resemblance between the two portfolios can be explained in thes. 52
17.following way: (1) The expected income provided by the discounted debts. 52
18.instrument in the first portfolio is replicated by the long position in thes. 52
19.underlying in the second portfolio. (2) The possible windfall gains provided bys. 52
20.the long call option in the first portfolio is replicated by the long position in thes. 52
21.underlying asset in the second portfolio. Furthermore (3), the lack of thes. 52
22.downside risk on the underlying in the first portfolio is replicated in the seconds. 52
23.portfolio by the long put option, which eliminates the downside risk of the longs. 52
24.position in the underlying.s. 52
25.In the above example, the two portfolios provide identical payoffs.s. 52
26.Consequently, on the basis of a no-arbitrage assumption, the values of thes. 52
27.portfolios must be equal. The relationship between the two portfolios is betters. 52
28.known as put-call parity.s. 52
(2.17) C + B = P + A
1.Put-call parity entailing the value of a call option (C) and a bond (B) equallings. 52
2.the value of a put option (P) and an asset (A).s. 52
3.Put-call parity is useful for purposes of financial engineering, as it illustratess. 52
4.that it is possible to replicate any position in the different securities in the “put-s. 52
5.call parity formula” simply by taking long and/or short positions in the others. 52
6.three securities.s. 52
The Relationship Between Options and Forwards
1.The relationships illustrated here, primarily used for derivative pricing,s. 52
2.demonstrate how derivatives can be used to replicate various financial positions.s. 52
3.40 For example, the relationship between spot prices and forward prices entails that a long position in a forward is financially equal to a portfolio involving a short position in a bond and a long position in the underlying of the forward. Using the equation of put-call parity shows that a portfolio entailing a short position in a bond and a long position in an underlying (asset) is financially equal to a long call option and a short put option:s. 52
(2.18) C-P = A-B
1.Similarly, the relationship between spot prices and forward prices implies that a short forward contract is financially equal to a portfolio of a long position in a bond and a short position in the underlying (asset). Consequently, put-call parity verifies that a short forward contract can be replicated by a long put option and as. 53
short call option:
(2.19) P-C = B-A
Basic Building Block Financial Instruments
Two Types of Building Blocks
1.In Section 2.2 I make the point that income can be divided into expected income (or expenses) and windfall gains (or losses). A windfall gain is a result of unexpected events that change an investment’s possibility of providing income – a result of risk. On the contrary, expected income is the total income of an investment that has not been subject to any unexpected events that may change its possibilities of providing income. Consequently, the division of income into two categories is based on risk.s. 53
2.In Sections 2.4.4 and 2.5.2, I discuss how derivatives can be used to transfer the risk of any type of underlying. In a no-arbitrage environment, derivatives can be used to replicate any financial position, providing windfall gains or losses. Consequently, together with credit-extension instruments that generally provide expected income, derivatives can be used to replicate any financial position. For this reason, derivatives and credit-extension instruments are jointly referred to as basic building block financial instruments.s. 53
Derivatives
1.The nature of derivatives has been thoroughly analyzed in Sections 2.3 – 2.5. From this examination, it follows that a price-fixing derivative transfers the 41s. 53
2.entire risk of its underlying, whereas a price-insurance derivative transfers eithers. 54
3.upside risk or downside risk of its underlying.s. 54
Credit-extension Instruments
1.A credit-extension instrument is an instrument in which a long position involvess. 54
2.the advance of capital for a defined period in consideration of compensation fors. 54
3.the capital. The party in a short position of a credit-extension instrument has tos. 54
4.pay compensation for being allowed to use the invested capital.s. 54
5.Credit-extension instruments are generally divided into the following fours. 54
6.categories: level-coupon instrument, zero-coupon instrument, floating-rates. 54
7.instrument, and amortizing instrument. However, in this study only level-s. 54
8.coupon instruments and zero-coupon instruments are considered.s. 54
9.Level-coupon instruments and zero-coupon instruments are characterized bys. 54
10.the fact that the total cash flow of such instruments can be predicted at theirs. 54
11.inception, because the payoff is based on a fixed rate in relation to the principles. 54
12.amount of the instrument. For example, a long position in a zero-coupons. 54
13.instrument with duration of 18 months and a principle amount of 100 will costs. 54
14.86 if the fixed interest rate is 10 percent. Thus at the duration of the contract,s. 54
15.the party in a short position has to pay to the party in a long position an amounts. 54
16.of 100, of which 86 is return of the initial payment and 14 is expected income.s. 54
17.POs. 54
18.EIs. 54
19.FRs. 54
Figure 2.6 The payoff from a zero-coupon bond
1.If a zero-coupon bond is held to maturity, its payoff (PO) is perfectlys. 54
2.predictable – it is expected income (EI). Consequently, the payoff does nots. 54
3.change because of unexpected changes in, for example, the floating interests. 54
4.rate (FR).s. 54
5.42 The way in which level-coupon instruments and zero-coupon instruments work implies that their payoff is perfectly predictable – that it can be classified as expected income. In principle, the only way such an instrument does not pay expected income is if the debtor (the party in a short position of the contract) defaults. However, the default risk of these contracts is generally low. Therefore, in this study, level-coupon instruments and zero-coupon instruments are considered to be instruments providing expected income to the party in a long position of the contract.s. 54
Synthetics
Replicating Payoff
1.In Section 2.6.2.1 I argue that the basic building block financial instruments (derivatives and credit-extension instruments) can be used to replicate the payoff from any financial position. A replicating position is generally referred to as a synthetic investment – a synthetic. Thus a portfolio of basic building block financial instruments, the payoff of which is identical to a share, is generally referred to as a synthetic share.s. 55
2.In a no-arbitrage environment, the payoff from a financial instrument is determined by its risk exposure. Thus a synthetic is constructed by creating a portfolio with a risk exposure identical to the replicated position.s. 55
3.There are innumerable ways in which synthetic positions may be created by means of the basic building block financial instruments. However, to illustrate the principles of how to create synthetics, the following sections portray synthetic positions in four investments that are usually considered to be quite different: These are positions in a regular capital asset, an equity, a debt, and a derivative.s. 55
Synthetic Capital Assets
1.A rational investor who invests in a capital asset such as gold expects the value of the gold to increase at least as much as the value of a risk-free investment such as a credit-extension instrument. Thus from the perspective of an investor, a capital asset pays an expected income that is at least as great as the expected income from a credit-extension instrument. Furthermore, as a capital asset is exposed to risk, it is possible that the asset also pays windfall gains or losses. Consequently, to replicate a long position in gold, it is necessary to take a long position in a credit-extension instrument such as a zero-coupon bond, because such an instrument provides expected income. Furthermore, it is necessary to enter into a derivative that transfers the total risk of gold to its holder. Such derivative position is typically a long forward contract. As a result, instead of 43s. 55
2.investing in gold, it is equally valuable to invest in a zero-coupon bond and,s. 56
3.simultaneously, to take a long position in a forward with gold as its underlying.s. 56
Synthetic Equity
1.A common share is typically equity, and it gives its holder a certain influence ons. 56
2.the governance of the company, as well as a residual right in the assets of thes. 56
3.company after company debts have been settled. These characteristics seem tos. 56
4.make people think of common shares as standard capital market instrumentss. 56
5.with unique cash flows. As with cash flows of any other capital asset, however,s. 56
6.it is possible to replicate the payoff from a common share by means of the basics. 56
7.building block financial instruments.s. 56
8.In principle, a share evidences interest in a portfolio involving certains. 56
9.corporate assets, and sometimes also corporate debt. Consequently, whens. 56
10.replicating a common share, it is in fact the net payoff of the corporate assetss. 56
11.and the corporate debt that is to be replicated. It is important therefore tos. 56
12.differentiate between the payoff profiles of leveraged companies and companiess. 56
13.that are financed solely by their owners.s. 56
14.In the case of a solely equity-financed company, a synthetic share is createds. 56
15.by a portfolio of long positions in the corporate assets. Another way of creatings. 56
16.such a synthetic share is to enter into long positions in synthetic corporates. 56
17.assets. However, for a leveraged company, the case is a little different.s. 56
18.In principle, a share in a leveraged company is a combination of a longs. 56
19.position in the corporate assets and a short position in the corporate debt. Froms. 56
20.the concept of put-call parity, it follows that such a position equals a positions. 56
21.involving a long call option and a short put option, which, in fact, equals thes. 56
22.position of a long forward. Consequently, in principle, the payoff of a shares. 56
23.can be replicated by taking a long position in a forward on the corporate assets.s. 56
24.However, unlike a position in a forward contract, which has an unlimiteds. 56
25.exposure to the downside risk of its underlying assets, shareholders have as. 56
26.limited exposure to the downside risk of the corporate assets because, due tos. 56
27.corporate legislation, the shareholders risk only the money they invest.s. 56
28.Consequently, the position of a shareholder is more like the position of a holders. 56
29.of a call option. This means that instead of holding a share, it is equally good tos. 56
30.take a long position in a call option with the corporate assets and the corporates. 56
31.debt as its underlying. In fact, this means that the payoff of a share is equal tos. 56
32.the payoff of a long call option on that share.s. 56
33.In theory it is also possible to replicate the payoff of shares withouts. 56
34.references to the actual share. Instead of purchasing a share in a leverageds. 56
35.44 company, it is possible to short credit-extension instruments and to use the capital to finance the purchase of corporate assets. In that way, it is possible to mirror the balance sheet of a company, and thus also track its possible payoff. However, because a share involves limited liabilities – limited downside risk of the corporate assets – it is also necessary to take a long position in a put option on the corporate assets. Thus instead of purchasing a share in a leveraged company, it is equally good to short credit-extension instruments, purchase corporate assets, and purchase a put option with the corporate assets as its underlying.s. 56
Synthetic Debt
1.The total payoff of a debt instrument (a credit-extension instrument) is considered to be expected income. Consequently, synthetic debt is a financial position exposed to a minimum of risk. To achieve such a position, a company may transfer away the total risk of an asset (e.g. a common share) that it possesses. Thus a long position in synthetic debt is accomplished by taking a long position in, for example, a share, and a short forward with the share as its underlying. It is also possible to accomplish synthetic debt by using options to create a synthetic long forward at one price and a synthetic short forward at a different price.s. 57
2.An important difference between a synthetic forward and a real forward is that it is possible to attribute the delivery price of the synthetic forward to something other than the forward price of the underlying asset. This is so because the strike price of an option is not the forward price of the underlying; rather the price is decided in accordance with the regulations on the exchange where it is traded; or if traded on the OTC market, on basis of the intention of the contracting parties. Thus by using two synthetic forwards, it is possible to enter into a long forward contract and to enter simultaneously into a short forward contract with the same underlying asset and the same duration, but with different delivery prices. Such a combination is generally referred to as a box spread, and it provides exactly the same payoff as a debt instrument.s. 57
3.With an interest rate of 5 percent, for example, a one-year zero-coupon bond with a principle amount of 100 provides a total payoff of approximately 5. However, instead of taking a long position in such instruments, it is equally good to take a long position in a synthetic forward with a delivery price of 5 and to enter simultaneously into a short position in a forward contract, the only difference between the contracts being that the delivery price in the latter is 10. 45s. 57
4.Independent of the value of the underlying of the synthetic forwards, the nets. 58
5.payoff of the positions will always be 5, as illustrated below:s. 58
Table 2.1 Payoff from a box spread
1.Independent of the value of the underlying (see the ten different scenarioss. 58
2.below), the payoff from a box spread is always constant.s. 58
3.If the delivery price of the long forward is greater than the delivery price of thes. 58
4.short forward, the net payoff of the synthetic debt is always negative. In thats. 58
5.way, it is possible to replicate a short position in debt.s. 58
Synthetic Derivatives
1.Finally, derivatives may be replicated by positions in other derivatives. Sections. 58
2.2.5.2.3 illustrates how a long call option and a short put option equals a longs. 58
3.forward, and how a short forward can be replicated by a combination of a longs. 58
4.put option and a short call option. However, it is also possible to create synthetics. 58
5.options. Considering that a long forward carries the total risk of its underlyings. 58
6.and a long call option carries only the upside risk of its underlying, it is possibles. 58
7.to conclude that, if the downside risk of a long forward is transferred away, its. 58
8.will replicate the position of a long call option. Thus a portfolio with a longs. 58
9.forward and a long put option equals a long call option. Furthermore, a portfolios. 58
10.with a long forward and a short call option equals a short put option. A long puts. 58
11.option can be replicated by a short forward and a long call option; and, finally, its. 58
12.is possible to replicate a short call option by using a short forward and a shorts. 58
13.put option.s. 58
14.46s. 58
Non-Traditional Financial Instruments
Financial Innovations
1.Besides replicating the payoffs from existing financial instruments (i.e. creating synthetics), basic building block financial instruments are used to create positions with net payoffs that have no equivalence in traditional financial instruments; these are called non-traditional financial instruments. Together with synthetics, such positions are sometimes referred to as financial innovations.s. 59
2.It is possible to create a financial position with no equivalence by disaggregating an existing financial instrument. For example, it is possible to separate and sell the dividend rights of a share and retain the capital appreciation component of it, thereby creating two non-traditional financial instruments. Alternatively it is possible to combine a number of basic building block financial instruments in a way that makes the net payoff from the combination unique. In this study, focus is on the latter type of financial innovation – composite contracts.s. 59
Composite Contracts
Raising Capital and Managing Risk
1.Composite contracts are either combinations of credit-extension instrument and derivatives or a combination of derivatives. The former type of composite contract, generally used for purposes of raising capital, is thoroughly examined in Chapters 5 and 6. Because the latter type of composite contract is a combination of derivatives, it entails a proportionally low initial investment and is therefore unsuited for raising capital. Rather, this type of composite contract is often used for risk management purposes. Among the most popular instruments of this type are caps, floors, and collars.s. 59
Caps
1.Interest rate caps are generally used to hedge against unfavorable fluctuations in a floating interest rate. An interest rate cap can be used to hedge a short position in a floating rate (debt) instrument, for instance. If the floating interest rate rises above a specified level (i.e. the cap rate), the cap provides a payoff to compensate for interest rate costs exceeding the principal amount multiplied by the cap rate.s. 59
2.An interest rate cap can be viewed as a portfolio with a number of interest rate call options (caplets) settled on regular basis. The strike price of these options is equal to the cap rate and they are therefore in the money when the 47s. 59
3.floating interest rate exceeds the cap rate. Options in the money are settled net ins. 60
4.cash, and thus provide a payoff corresponding to the interest rate expenses ins. 60
5.excess of the sum of the principle amount and the cap rate. Consequently, takings. 60
6.a long position in an interest rate cap ensures that the interest rate costs of as. 60
7.floating rate (debt) instrument never exceed the principle amount of thes. 60
8.instrument multiplied by the cap rate.s. 60
Floors
1.As for an interest rate cap, an interest rate floor is a composite derivatives. 60
2.instrument designed to hedge against unfavorable movement in a floatings. 60
3.interest rate. Analogous to caps, floors can be viewed as a portfolio of regularlys. 60
4.settled options (floorlets), that is, interest rate put options. Setting the strikes. 60
5.price of put options equal to the floor rate (cf. cap rate), the options are in thes. 60
6.money when the floating interest rate is below the floor rate. Consequently, as. 60
7.long position in an interest rate floors provides a payoff when the interest rates. 60
8.falls below the floor rate. Thus a floor can be used to hedge a long position in as. 60
9.floating rate (debt) instrument.s. 60
Collars
1.A portfolio involving a long position in a cap and a short position in a floor iss. 60
2.known as a collar or a floor-ceiling agreement. A collar may be used to ensures. 60
3.that the interest rate cost of a floating interest rate note stays between two levelss. 60
4.– the cap rate and the floor rate. Usually the price of the cap is initially set at thes. 60
5.same level as the price of the floor, and therefore the cost of entering into as. 60
6.collar is zero.s. 60
7.48s. 60
8.Vs. 61
9.IRs. 61
Figure 2.7 The function of a collar
1.The figure shows how a collar can be used to guarantee that the floating interest rate cost stays between two levels. V is value of the company and IR is interest rate. Analogous to the picture above, a short position in a cap and a long position in a floor can be used to make sure floating interest income stays between specified levels. In this study, such an arrangement is referred to as an inverted collar.s. 61
Conclusions
1.This chapter presents the analytical framework of this study – the economic substance of derivatives. As a basis for presentation of the analytical framework, the general concepts of income and risk have been used. Furthermore, the conclusions presented in this chapter are valid under a no-arbitrage assumption, which entails that the financial instruments dealt with are presumed to be traded on a market that is in perfect equilibrium.s. 61
2.Disregarding corporate income tax, a company’s income is defined as the largest amount the company can distribute to its shareholders during a period, 49s. 61
3.and end up as well of as it was in the beginning. This concept is generallys. 62
4.referred to as the Haig-Simons concept of income.s. 62
5.Risk is the possible deviation from the expected return of an investment.s. 62
6.Income generated from an investment for which the return does not deviate froms. 62
7.the expected is generally referred to as expected income. However, if somethings. 62
8.unexpected happens to make the return of an investment deviate from thes. 62
9.expected, the difference between the total return and the expected income froms. 62
10.that investment is referred to as windfall gains or windfall losses. Consequently,s. 62
11.expected income is the total income of a risk-free investment. Windfall gains ors. 62
12.losses are changes in the value of an investment that could not be anticipated ats. 62
13.inception of the investment – changes in value because of risk.s. 62
14.Derivatives are instruments that transfer risk between the contracting parties.s. 62
15.Thus the income that derivatives provide is windfall gains or losses. On thes. 62
16.contrary, credit-extension instruments, such as zero-coupon bonds or level-s. 62
17.coupon bonds are exposed to low risk, and therefore their payoff is, as a generals. 62
18.rule, expected income. As derivatives and credit-extension instruments represents. 62
19.two different types of income, they can be combined to replicate the return froms. 62
20.any capital investment. Derivatives and credit-extension instruments ares. 62
21.generally referred to as the basic building block financial instruments.s. 62
22.In a no-arbitrage environment, the return of an investment is entirely reliants. 62
23.on its risk exposure. Thus to replicate a financial position entails thes. 62
24.construction of a portfolio exposed to a risk identical to the financial positions. 62
25.that is replicated. It is possible to construct such a portfolio by taking longs. 62
26.and/or short positions in the basic building block financial instruments. As. 62
27.portfolio that replicates a financial position is generally referred to as as. 62
28.synthetic.s. 62
29.Combinations of building block instruments that do not replicate the payoffs. 62
30.of an already existing financial instrument are referred to in this study ass. 62
31.composite contracts. These financial instruments are generally constructed fors. 62
32.purposes of raising capital or for purposes of risk management. These contractss. 62
33.are characterized by their payoff profile, which has no equivalence among thes. 62
34.traditional financial instruments, and, are often referred to as financials. 62
35.innovations.s. 62
36.50s. 62
Tax Arbitrage and the General
Structure of the Swedish Income
Tax System
Legal Framework
1.Chapter 2 establishes the economic substance of financial instruments, in order to examine whether or not the Swedish income tax system provides tax arbitrage opportunities in relation to these instruments. That examination is conducted in Chapters 4, 5, 6, and 7, in which the income tax treatment of derivatives, composite contracts, and synthetics is examined. In order to facilitate that examination, it is necessary to identify the general provisions of the Swedish income tax treatment of financial instruments – more specifically, to establish the legal framework of the Swedish corporate income tax system. Therefore, most of this chapter deals with the basic structure of the Swedish income tax system. In Section 3.3 I discuss the fundamental income tax provisions relevant for non-financial companies. In Section 3.4, I present the general classification of income provided by financial instruments that are held by non-financial companies.s. 63
2.Whether or not the legal framework of the Swedish income tax system provides tax arbitrage opportunities cannot be appropriately analyzed, however, unless the contents of the term “tax arbitrage” is established. Thus before the examination of the legal framework, Section 3.2 provides a general discussion on the contents of “tax arbitrage” and the types of tax arbitrages that are relevant for this study. As a basis for this discussion, I examine the fundamentals of the concept of “income” as used in the Swedish income tax system. The conclusions of this chapter are presented in Section 3.5.s. 63
Tax Arbitrage
Defining Tax Arbitrage
1.Like any income tax system, the Swedish system changes constantly. In principle, these changes are either modifications of the way income is established or alterations to the income tax rate. As the income tax rates used in 51s. 63
2.the Swedish income tax system seldom change, it can be generally concludeds. 64
3.that changes in the Swedish income tax system concern the way taxable incomes. 64
4.is established – the contents of the legal concept of income.s. 64
5.In relation to the economic concept of income, which is theoreticallys. 64
6.coherent and thus static, every change in the income tax system alters thes. 64
7.relationship between the legal concept and the economic concept of income.s. 64
8.Thus this relationship is highly dynamic and continuously generates news. 64
9.inconsistencies.s. 64
10.If the same types of income, as defined in an economic context, are treateds. 64
11.inconsistently in the Swedish income tax system, the inconsistency has a value.s. 64
12.In other words, there is an arbitrage opportunity. For example, if the risks ofs. 64
13.assets X and Y are equal, but the payoff from asset X is tax exempt, while thes. 64
14.payoff from asset Y is taxed at a flat rate of 50 percent, a rational investor woulds. 64
15.choose to invest in asset X, which provides a greater payoff at the same cost. Ass. 64
16.Miller argues, if an income tax system remained unchanged for a generation ors. 64
17.more, equilibrium could emerge, in which the gains possible from exploitings. 64
18.arbitrages would be neutralized by the cost of the investment. Mores. 64
19.specifically, the income tax system would be a no-arbitrage environment.s. 64
20.Because the income tax system changes constantly, however, it will alwayss. 64
21.provide opportunities for arbitrages – that is, opportunities for tax arbitrage.s. 64
22.Based on this line of reasoning, a tax arbitrage can be defined as the use ofs. 64
23.economic equivalencies in order to exploit inconsistencies in the income taxs. 64
24.system. Kane refers to the existence of regulatory arbitrages such as taxs. 64
25.arbitrages as a regulatory dialectic, the driving force of which is: “…the inherents. 64
26.conflict between attempts to regulate and attempts of regulated parties to lessens. 64
27.the burden of whatever regulations apply to them...”. For Swedish non-financials. 64
28.companies, there are no inconsistencies in the rate at which income is taxed: Alls. 64
29.income is taxed at a flat rate of 28 percent. Consequently, the arbitrages. 64
30.opportunities occur according to the way the taxable income is established. Wes. 64
31.now examine how taxable income is defined in the Swedish income tax systems. 64
32.and the types of tax arbitrage opportunities provided by the system.s. 64
Realization vs. Fair-value
1.In Section 2.2.1, Chapter 2, the Haig-Simons concept of income is defined as thes. 64
2.maximum amount a company can distribute to its shareholders yet be as well offs. 64
3.at the end of a period as it was at the beginning. How to establish the worth ofs. 64
4.the distributed amount or the capital of the company at the end of a period is nots. 64
5.implicit in the concept. In practice two approaches to establish the worth haves. 64
6.52 been developed: the realization approach and the fair-value approach. The principal difference between these two approaches is the amount of judgment allowed when establishing the income. According to the realization approach, only worth that is a result of realization constitutes income. Thus by solely recognizing the surplus of an arm’s length business transaction as income, the realization approach limits the subjectivity connected to valuation. The fairvalue approach, on the other hand entails the recognition of any change in the value of a company’s assets. Thus the amount of income recognized is dependent on the application of various valuation methods, which, by their nature, involve a great deal of subjectivity.s. 64
7.The reason these two approaches have developed so differently can be explained in the context of financial accounting, in which both approaches are commonly used. Financial accounting is a process that produces selected financial information about a company. The process is instrumental, which implies that it does not have a function in and of itself, but is used to fulfil certain purposes. Consequently, it is the requests from users of the financial reports that set the purposes for financial accounting.s. 65
8.There are several users of financial reports, which are generally divided into two principal groups: creditors and capital investors. Because the two principal groups require different information from the financial reports, different accounting systems have developed.s. 65
9.As the greatest concern for creditors is to protect their investments – the company’s debt – from falling in value, creditors are interested in financial information that presents the value of a company’s assets and its distributable profit in a prudent and reliable way. Consequently, it is not in the interest of creditors to allow representatives of the debtors – the companies – to estimate the value of their assets without restrictions; and it is not in the interest of the creditors to allow the owners of the companies to distribute as much profit as they like. Instead, creditors benefit from regulations that clearly deprive debtors of the right to estimate the worth of their assets and make them recognize them in a predictable and prudent way. It is also in the interest of the creditors to restrict the debtors’ possibilities for recognizing income in the profit and loss account; because profit may be distributed and thereby lower the worth of the credits. Consequently, accounting systems supporting the interests of creditors generally limit possibilities for judgments. Thus fundamental principles in accounting systems that focus on creditors’ protection are prudence and realization.s. 65
10.The situation in accounting systems that support investors’ interest is, in some respects, the opposite. Investors receive their compensation in the form of dividends or from capital gains resulting from appreciation of the value of their 53s. 65
11.shares in the company. The size of the dividend and the appreciation of thes. 66
12.value of the shares are directly dependent on the profit of the company.s. 66
13.Consequently, an investor needs information to predict the future earnings of thes. 66
14.company. To satisfy the needs of investors, financial reports must reflect thes. 66
15.commercial reality of the company, including the facts that the structure, value,s. 66
16.and profit of a company changes from time to time. Such accounting systemss. 66
17.must allow a certain degree of judgement; otherwise it would be impossible tos. 66
18.create financial reports that reflect commercial reality. Thus accounting systemss. 66
19.that serve an investor’s perspectives support a fair-value approach to valuation.s. 66
20.To summarize, the Haig-Simons concept of income appears to be different,s. 66
21.depending on whether it is established on the basis of a realization approach ors. 66
22.on the basis of a fair-value approach. The realization approach has developed ass. 66
23.a concept to limit subjectivity in establishing income; whereas the fair-values. 66
24.approach has developed as a concept that provides the most relevant perspectives. 66
25.of income from a commercial or economic viewpoint.s. 66
The Ability to Pay Income Taxes
1.The subjects of every state ought to contribute towards the support of thes. 66
2.government, as nearly as possible, in proportion to their respectives. 66
3.abilities; that is, in proportion to the revenue which they respectivelys. 66
4.enjoy under the protection of the state.s. 66
5.This citation expresses the first maxim of taxation in Adam Smith’s An Inquirys. 66
6.into the Nature and Causes of the Wealth of Nations. This maxim is often useds. 66
7.as a reference to the ability-to-pay principle, which is the basis for most incomes. 66
8.tax systems around the world, including that of Sweden. In Sweden, thes. 66
9.essence of this maxim appears in two principles – horizontal equity and verticals. 66
10.equity. Usually they are explicitly referred to in the preparatory works to the taxs. 66
11.legislation.s. 66
12.To appreciate the Adam Smith citation, it is necessary to establish thes. 66
13.contents of the term “revenue” as used therein. The contents of the citation ares. 66
14.different if “revenue” is a reference to income as established on the basis of as. 66
15.realization approach versus a fair-value approach. In principle, both alternativess. 66
16.are possible, and are used in different contexts to legitimate the taxation ofs. 66
17.income (and wealth). However, in the Swedish income tax system, the ability-s. 66
18.to-pay principle means that the ability to pay income taxes occurs when the taxs. 66
19.54 subject has converted capital into cash or cash equivalents. More specifically, it occurs after the tax subject has realized capital investments (or manpower). Thus in the Swedish income tax system, the term “revenue”, as used in the Adam Smith citation, generally refers to income established on basis of a realization approach.s. 66
Income
1.On the basis of the Haig-Simons concept of income, the realization approach, and the ability-to-pay principle, it appears that the concept of income as used in the Swedish income tax system is a theoretically coherent concept, the contents of which is the surplus of realized (manpower or) capital investments. However Sweden’s use of the income tax system as a means of accomplishing various political considerations has made it impossible to maintain a theoretically coherent concept of income. Therefore, it is politics rather than economic theories that eventually decide the concept of income.s. 67
2.Sweden’s inclusion of political considerations has resulted in an economically inconsistent concept of income, in that both the realization approach and the fair-value approach are used as a basis for income recognition. Using these two approaches in the same income tax system challenges the equity of the system and provides tax arbitrage opportunities. More specifically, it provides timing arbitrage opportunities.s. 67
Timing Arbitrage
Defining Timing Arbitrage
1.Whether income is established on the basis of a realization approach or a fairvalue approach, it is defined as an increase in value during a certain period – the income period. Thus the principal difference between the two approaches is not the contents of income, but the fact that they favour different methods of recognizing it.s. 67
2.The two approaches differ in the sense that the fair-value approach involves the recognition of income every income period, whereas the realization approach implies recognition of income only at the time of realization. Consequently, if a company holds an asset during two income periods, the amount of income attributable to that company will differ depending on which 55s. 67
3.approach is applied when the income is established. The following examples. 68
4.illustrates this point:s. 68
5.Example:s. 68
6.A company purchases an asset for 100 in Year 1. At the end of Year 1,s. 68
7.the fair-value of the asset is 150. In Year 2 the company disposes of thes. 68
8.asset at a price of 200.s. 68
9.If the income is established on the basis of the realization approach, thes. 68
10.company must recognize an income of 100 (200 - 100) in Year 2, whens. 68
11.the asset is realized. However, if the income is established on the basiss. 68
12.of a fair-value approach, the company must recognize an income of 50s. 68
13.(150 - 100) in Year 1 and an income of 50 (200 - 150) in Year 2.s. 68
14.This example illustrates that income may be recognized in different periodss. 68
15.depending on the approach used to establish it. Generally, if something is treateds. 68
16.differently independent of its character, but solely on the basis of the context ins. 68
17.which it is subject to treatment, the different treatment is referred to as ans. 68
18.arbitrage. Thus if a company may choose which of the two approaches to applys. 68
19.for income recognition, it has an arbitrage opportunity, and may choose thes. 68
20.more favourable of the two possible approaches. An arbitrage that presents ans. 68
21.opportunity to choose which income period is used for income recognition iss. 68
22.generally referred to as a timing arbitrage.s. 68
Tax Credit
1.A timing arbitrage may create tax benefits for a tax subject. For example, as. 68
2.rational tax subject with the opportunity to choose whether income is to be taxeds. 68
3.in year X1 or year X2 would prefer taxation year X2. This is so because thes. 68
4.deferred income tax can be invested for an additional income period (one year)s. 68
5.and in that way generate income that otherwise would have been impossible tos. 68
6.make.s. 68
7.In principle, an opportunity to defer taxation, like in the example presenteds. 68
8.above, can be seen as the state offering the tax subject a one-year, interest-frees. 68
9.loan, the principal amount of which equals the deferred income tax. Thus a taxs. 68
10.subject that has taken advantage of the opportunity of deferred taxation iss. 68
11.generally said to have utilized a tax credit.s. 68
12.As is pointed out in Section 3.2.1, tax arbitrage opportunities may arise whens. 68
13.the payoffs from two economically equal financial positions are classified, ands. 68
14.thereby taxed, differently. By investing in the financial position in which thes. 68
15.payoff is taxed most favorably, it is possible to utilize the tax arbitrage and tos. 68
16.receive a tax credit. In principle, such action does not challenge the income taxs. 68
17.56 provisions. However, if the intention of the action is to avoid taxation, it can be argued that it is contrary to the tax provisions anyway, and that the action constitutes tax avoidance.s. 68
Tax Avoidance and Recharacterization
1.The decision about whether or not the employment of a tax arbitrage is to be considered as tax avoidance must eventually be made on the basis of the Swedish Tax Avoidance Act. According to this act, transactions shall be discarded from income tax assessment if the following four conditions are fulfilled: (1) the transaction results in essential tax advantages; (2) the tax subject is directly or indirectly involved in the transaction; (3) the general purpose of the transaction is to achieve the tax advantages; and (4) a tax assessment based on the form of the transaction would contradict the purpose of the relevant tax rules, as interpreted from the relevant rules and the statutory tax rules in general. Few cases have been examined against the Tax Avoidance Act, probably because it is difficult to establish that all four conditions have been fulfilled.s. 69
2.Other than through the application of the Swedish Tax Avoidance Act, taxmotivated transactions can be prevented with reference to the general principle of recharacterization. This principle entails that it is the “real” substance of a transaction, rather than its designation by the tax subject that decides its income tax treatment. As a basis for such recharacterization, the character of the transactions in accordance with civil law is imperative. Thus the core issue of recharacterization is to identify the possibilities and the limits of reaching another characterization in tax cases than in civil law cases.s. 69
3.It is uncertain if the principle of recharacterization is effective in preventing tax arbitrage opportunities related to a financial instrument. Recharacterizing a financial instrument in accordance with civil law does not necessarily entail that 57s. 69
4.its character mirror its economic substance. If it does not, the arbitrages. 70
5.opportunities will remain.s. 70
Establishing Legal Form
1.As noted previously in this chapter, tax arbitrage opportunities arise when thes. 70
2.payoff from two economically equal financial positions are treated differentlys. 70
3.because their legal form differs. The way in which the legal form of a payoff iss. 70
4.decided in the income tax system creates interdependence among threes. 70
5.elements: the legal form of the tax subject, the legal form of the asset thats. 70
6.generates the payoff, and the character of the payoff itself. Thus to establish ands. 70
7.analyze the situations in which financial instruments create tax arbitrages. 70
8.opportunities, it is necessary to examine the legal framework in which the legals. 70
9.form of the payoffs is established. That examination is conducted in thes. 70
10.remainder of this chapter.s. 70
Fundamentals on the General Structure of the Swedish
Corporate Income Tax System
Income from Business
1.The basis for classifying income in the Swedish income tax system wass. 70
2.originally the source principle. Income was defined with reference to a durables. 70
3.income source, and the payoff from one income source was treated separatelys. 70
4.from the payoffs from other income sources. Thus although a tax subject coulds. 70
5.hold several different income sources, the net payoff – the income – from thes. 70
6.different sources was computed separately. Today, the income source principles. 70
7.has limited relevance to the way income is established according to the Swedishs. 70
8.income tax system; instead of income sources, the income of a tax subject iss. 70
9.classified into income tax schedules. The income earned by a company iss. 70
10.considered to be within the income tax schedule, Income from business.s. 70
Ordinary Business
1.Although jointly considered as income from business, a company’s income iss. 70
2.treated differently depending on whether it is a result of the company’s ordinarys. 70
3.58 business or a result of the company’s capital management. The concept of ordinary business has its origin in the Municipal Tax Act of 1928, in which the income source Business was introduced, and defined as a professional and independent activity for the purpose of making profit. Furthermore, the influence of the source principle signifies that an activity within its scope had to be continuing. These characteristics are still relevant when deciding whether or not income is regarded as being derived from a company’s ordinary business.s. 70
4.In the literature of today, a company’s ordinary business is defined as any activity that is aimed at generating a commercial exchange – a profit – and is conducted on a regular basis. By “regular basis”, it is meant that the activity shall be carried out over a period of time and involve a certain number of transactions. However, if the activity is of an extensive character, it may be considered an ordinary business even if the transaction is not conducted over a period of time. Furthermore, it is eventually the market that decides whether or not the activity carried out by a business is a value-generating activity. Thus an activity that generates value, like an ordinary business, is normally aimed at an interested external party – normally customers.s. 71
Financial Instruments and Ordinary Business
1.The nature of financial instruments signifies that the only way they can be used in a value-generating activity is if they are offered for sale on a public market. Thus financial instruments are considered to be part of a company’s ordinary business only if they are subject to trading and the trade corresponds to what is defined as an ordinary business. An ordinary business involving trading with financial instruments is generally referred to as a security business. In most situations, security businesses are operated by companies classified as, for instance, banks or insurance companies – financial companies – that are treated 59s. 71
2.in accordance with special provisions for income tax purposes. However, theres. 72
3.are situations in which businesses that are not operating as financial companiess. 72
4.have been considered as operating a security business.s. 72
Security Business
1.Whether or not a tax subject operates a security business cannot usually bes. 72
2.established with reference to the actual activity – security trade – because anys. 72
3.business may carry out such activity, for purposes of capital management, fors. 72
4.example. Instead, with reference to the definition of ordinary business, as. 72
5.distinction is made on the basis of the circumstances in every special case. Thes. 72
6.focus is on the value of the traded securities, the frequency of the trade, and thes. 72
7.time securities held by the tax subject. Furthermore, in establishing whether ors. 72
8.not a tax subject is to be treated as a security business, differences ares. 72
9.recognized between individuals and limited companies. The security trade of ans. 72
10.individual must aim at customers in order for that individual’s activity to bes. 72
11.classified as a security business. A limited company can be classified as as. 72
12.security business even though its entire security trade is conducted in relation tos. 72
13.an exchange. Thus in principle, it is not possible for individuals to constitute as. 72
14.security business.s. 72
15.Court decisions concerning the concept of a security business generally deals. 72
16.with individuals and limited companies. How to classify legal persons that ares. 72
17.not limited companies cannot be satisfactorily established on the basis of thes. 72
18.case law, however. Thus a current issue in the Swedish income tax system is thes. 72
19.classification of foundations and non-profit associations that manage theirs. 72
20.capital in a professional way, but deal with an exchange as their onlys. 72
21.counterpart. One possible way of classifying security businesses has beens. 72
22.presented in a government report. The suggested classification signifies that, ins. 72
23.order to be classified as a security business, a subject must be licensed tos. 72
24.conduct such business by the Swedish Financial Supervisory Authority.s. 72
25.Whether or not this suggestion will influence the legal situation of the concepts. 72
26.of security business has not yet been resolved. Whether the suggestion puts. 72
27.forward in the governmental report will be approved or whether the legals. 72
28.situation will continue to be established in case law, however, the vast majoritys. 72
29.60 of companies are not to be considered to be security businesses; i.e. they are non-financial companies.s. 72
Income from Ordinary Business and Income from Capital
Management
Recognition of Income
1.Because financial instruments are considered as part of a company’s ordinary business only if the business is conducting a security business, it is possible to conclude that a financial instrument provides income from capital management when held by a non-financial company. The principle difference between the income tax treatment of income from a company’s ordinary business and income form its capital management is the way in which the income is recognized: Whereas income from a company’s capital management is recognized on the basis of a realization approach, the income from a company’s ordinary business is, as a general rule, recognized on the basis of good accounting practice.s. 73
Good Accounting Practice
1.Income from a company’s ordinary business is recognized in accordance with good accounting practice because of the connection between the Swedish income tax system and financial accounting. The connection generally entails that the income recognition, as carried out in a company’s financial reports, is also adequate for income taxation if it is consistent with good accounting practice.s. 73
2.Good accounting practice is a legal standard complementing the relatively indistinct Swedish accounting legislation. Thus the contents of good accounting practice develop outside the traditional legal sources. However, only practice and sources that fulfil the requirements of being good can be used to establish good accounting practice. Practice refers to an actual applied accounting practice, and it is good if it is compatible with the accounting legislation and is theoretically and practically satisfactory. There is a strong presumption in Swedish financial accounting that, as a general rule, accounting 61s. 73
3.standards fulfil these requirements. Consequenlty, although not legally bindings. 74
4.as such, accounting standards have become imperative sources whens. 74
5.establishing the contents of good accounting practice.s. 74
6.Income recognition in accordance with good accounting practice is carrieds. 74
7.out in many situations on the basis of a realization approach. This is the cases. 74
8.because the Swedish accounting system traditionally focused on creditors’s. 74
9.protection. During the last decades, however, significant growth in the capitals. 74
10.market has shifted the focus of the accounting standard setters somewhat froms. 74
11.creditors’ protection to investor-oriented information. The shift in focus entailss. 74
12.that good accounting practice involves income recognition not only on the basiss. 74
13.of realization, but also on the basis of a fair-value approach. As a result, thes. 74
14.extent to which the connection between Swedish income taxation and financials. 74
15.accounting can remain has been questioned.s. 74
Accrual Recognition
1.In the context of good accounting practice, the realization approach, includings. 74
2.the related matching principle, is often applied on services and assets that ares. 74
3.used in a company’s ordinary business. If the services are conducted over mores. 74
4.than one income period, the realization approach must establish the extent tos. 74
5.which the service is realized over the different income periods. Similarly, if ans. 74
6.asset is held over more than one income period, the matching principle musts. 74
7.establish the extent to which the asset is consumed: the amount that can bes. 74
8.recognized as an expense. In other words, the realization approach is used tos. 74
9.establish accrued income and expenses. The judgments necessary to carry out ans. 74
10.accrual recognition make the realization approach somewhat subjective ass. 74
11.applied according to good accounting practice. This subjectivity does not exists. 74
12.when the realization approach is applied to financial instruments used by as. 74
13.company for capital management – that is, financial instruments that ares. 74
14.considered outside a company’s ordinary business. In such a case, the realizations. 74
15.approach entails income recognition only when a financial instrument iss. 74
16.disposed of. Compared to the realization approach applied on financials. 74
17.instruments, therefore, a realization approach applied under good accountings. 74
18.practice may require more judgment, as it must establish accrued income.s. 74
19.62s. 74
Accrual Recognition and Financial Instruments
1.In line with the general structure of the Swedish income tax system, income from financial instruments that are part of a company’s ordinary business – a security business – is to be recognized on an accrual basis. Recognizing income from financial instruments on an accrual basis involves the application of a fairvalue approach. Thus the treatment of a financial instrument for income tax purposes differs fundamentally when it is considered as part of a company’s ordinary business and when it is held for capital management. This difference in tax treatment illustrates the inconsistency in the concept of income as it occurs in the Swedish income tax system. Furthermore, in relation to this study, it makes it necessary to limit the examination of the income taxation of these instruments to either the financial instruments that are considered to be part of the ordinary business or the financial instruments that are used for capital management. A comprehensive examination entailing both types of financial instruments is considered to be too broad for a doctoral thesis. Thus the remainder of the study focuses on the income tax treatment of financial instruments held by non-financial companies – companies that do not conduct a security business – and on income from capital management attributable to nonfinancial companies.s. 75
Income from a Company’s Capital Management
Scope
1.Income from a company’s capital management refers in this study to a company’s taxable income that is not a result of that company’s ordinary business. Therefore, any payoff from a financial instrument held by a nonfinancial company is classified as income from capital management.s. 75
2.In principle, a financial instrument may provide payoff either before maturity, or/and at maturity/disposal Payoff provided before maturity/disposal is generally classified as interest or dividends, whereas payoff resulting from the disposal of a financial instrument is classified as capital gains or losses.s. 75
Capital Gains and Capital Losses
Defining Capital Gains and Capital Losses
1.In an economic context, a capital gain may be defined as an increase in value of an asset in which the increase is not related to improvements or real changes in 63s. 75
2.the asset. If the value of an asset changes independent of improvements ors. 76
3.deteriorations in the asset, the change must be a result of unexpected events – as. 76
4.result of risk. Consequently, in an economic context, capital gains or lossess. 76
5.equal what in this study is referred to as windfall gains or losses.s. 76
6.However, in the Swedish income tax system, the economic definition ofs. 76
7.capital gains or losses is of limited practical use. Rather, capital gains or lossess. 76
8.are used as a reference to gains or losses that is a result of the disposal of assets,s. 76
9.not as part of a company’s ordinary business. Classifying income that is nots. 76
10.generated in a company’s ordinary business as a capital gain or loss appears tos. 76
11.be common in most income tax systems. Thus it is likely that it is not only ins. 76
12.Sweden that gains or losses from the disposal of financial instruments held bys. 76
13.non-financial companies are typically classified as capital gains or losses.s. 76
Income Tax Treatment
1.A capital gain or loss is established as the difference between the cost ofs. 76
2.obtaining an asset and the remuneration received when it is sold. Capital gainss. 76
3.are part of a company’s taxable income, and are taxed, like any business income,s. 76
4.at a flat rate of 28 percent. However, when it comes to capital losses, thes. 76
5.situation is a little more complicated.s. 76
6.The income tax treatment of capital losses attributable to non-financials. 76
7.companies differs between capital losses from assets classified as debts. 76
8.instruments or non-financial items and capital losses from assets classified ass. 76
9.equity instruments.Capital losses from equity instruments can be offset onlys. 76
10.against capital gains from equity instruments; whereas any other capital loss cans. 76
11.be offset against any taxable income. Capital losses from equity instrumentss. 76
12.are treated differently from other kinds of capital losses because the goal is tos. 76
13.tax the payoff from capital investments in equity equally for individuals ands. 76
14.non-financial companies.s. 76
Equity, Debt, and Non-Financial Items
1.As discussed in the preceding section, the income tax treatment of capital lossess. 76
2.is dependent on the character of the asset from which the capital loss originates.s. 76
3.All assets are classified as equity instruments, debt instruments, or non-financials. 76
4.64 items. The definition of an equity instrument generally covers all contracts giving its holder a residual interest in the asset of a company after deducting all its liabilities. In addition, contracts with payoffs that are related to the payoff from an equity instrument are to be treated as equity instruments for income tax purposes.s. 76
5.A debt instrument is generally defined as a claim of a certain amount of currency. If the amount is stipulated in SEK, the claim is classified as a Swedish debt instrument; if it is stipulated in any other currency, it is considered a foreign debt instrument. The contents of the expression, debt, are not defined; nor are they exemplified in the legislation or in its preparatory works. Thus the expression is to be interpreted on the basis of its ordinary meaning.s. 77
6.The term “non-financial item” is not used in the income tax legislation. However, because any asset not within the scope of the terms “equity instrument” and “debt instrument” is, in fact, non-financial, it is reasonable to designate these assets as non-financial items. Examples of non-financial items are copper, grain, corn, or art held as capital investments outside a company’s ordinary business.s. 77
7.Derivatives are not covered by the scope of any of the three categories of assets previously mentioned. However, on the basis of the character of the underlying of a derivative, capital losses from a derivative shall be treated in accordance with the provisions relevant for the underlying of the derivative.s. 77
Dividends
1.Besides capital gains or losses, an equity instrument may provide a payoff classified as dividends. A dividend is not explicitly defined in the Swedish income tax legislation, but is generally considered to be the distribution of value between a company and its owner(s). In what manner of instrument the value is distributed is eventually decided by the general meeting of the company, in accordance with the provisions in the Swedish Company Act. As dividends are distributed on the basis of the net results of the company, they do not entail any deductions that reduce a company’s taxable income. 65s. 77
2.The concept of dividends is of minor importance in this study. Therefore,s. 78
3.this concept is left without further examination, as I focus on payoff classified ass. 78
4.interest.s. 78
Interest
Defining Interest
1.The concept of interest, as used in the Swedish income tax system, is not defineds. 78
2.in the legislation. Thus guidance on how to establish the concept must be founds. 78
3.in case law and preparatory works to the income tax legislation.s. 78
4.In the preparatory works, interest is generally regarded as payoff from debts. 78
5.instruments. More specifically, interest is defined as any payoff from a debts. 78
6.instrument that is not defined as a capital gain or a capital loss. Thus interest iss. 78
7.negatively defined on the basis of the definition of capital gains or losses.s. 78
8.However, case law on the income taxation of interest illustrates that, in manys. 78
9.situations, it is difficult to decide if the payoff from a financial instrument is tos. 78
10.be classified as interest or as capital gains or losses. Furthermore, case law ons. 78
11.the income tax treatment of financial instruments indicates that interest iss. 78
12.provided, not only by debt instruments, but also by the holding of an equitys. 78
13.instrument. Thus case law does not give an unambiguous answer to thes. 78
14.question of how to define interest, and therefore the interest definition iss. 78
15.uncertain.s. 78
16.When dealing with the concept of interest as used in the Swedish income taxs. 78
17.system, references are generally made to an economic concept of interest and tos. 78
18.a formal concept of interest. The economic concept of interest can be defined ass. 78
19.the price paid for the use of capital. A formal concept of interest focuses solelys. 78
20.on the way income is classified. In principle, such a concept signifies that onlys. 78
21.income that is designated to be interest can be taxed as such.s. 78
Interest – the Economic Concept
1.In the previous section of this chapter, the economic concept of interest iss. 78
2.defined as the price paid for the use of capital, a definition that is establisheds. 78
3.from a debtor’s perspective. This is so because all payments made by a debtors. 78
4.66 on the basis of a debt instrument are expenses paid for the right to use the principle amount of the instrument. Thus from a debtor’s perspective, it is possible to conclude that any payoff connected with a debt instrument is covered by the economic definition of interest. Furthermore, as the payoff paid by a debtor is always a product of the principle amount of the debt instrument, its interest rate, and its duration, the payoff is predictable.s. 78
5.The payoffs paid by a debtor to a creditor constitute, by definition, interest income in the hands of the creditor. From a creditor’s perspective, however, interest is not the only possible payoff connected to a debt instrument. In cases in which a debt instrument is subject to trading, the creditor may utilize any changes in the value of the instrument. Such possibilities arise in relation to debt instruments with a fixed interest rate, as the value of such instrument changes in relation to changes in the market price of capital: the market interest rate. Consequently, if two identical debt instruments are purchased at different prices, they will provide different amounts of income, although the amount of interest they generate is the same. Therefore, from a creditor’s perspective, it is not possible to conclude that any payoff connected with a debt instrument is covered by the economic definition of interest. Some of the payoff may be other types of income in the form of capital gains.s. 79
6.Furthermore, it is important to emphasize that, according to the economic definition of interest, it is only remuneration for the use of capital that is covered. The price of capital is eventually decided by the market. Thus if the amount of payoff paid by a debtor to a creditor differs substantially from the amount that would have been paid if the payoff from the debt instrument were established on the basis of the market interest rate, the payoff is not interest in an economic sense.s. 79
7.To summarize, the economic concept of interest covers any remuneration from a debtor to a creditor for the use of capital. From a debtor’s perspective, this means that all payoffs from a debt instrument are interest. From a creditor’s perspective, however, this is not the case, because some of the payoffs attributable to a creditor may be a result of unexpected changes in the price of capital. Consequently, if the economic concept of interest were to be applied in the Swedish income taxation, the payoffs from debt instruments would cause difficulties for creditors, as they would have to separate the payoffs from every single debt instrument into interest and capital gains. Thus in the Swedish income taxation system, the content of interest is established from a formal point of view. 67s. 79
Interest – the Formal Concept
1.The formal concept of interest, as used in the Swedish income tax system,s. 80
2.focuses on whether or not the payoff that is designated to be interest iss. 80
3.predictable. As argued in the previous section, predictable payoff connecteds. 80
4.with a debt instrument is covered by the economic interest definition if it is paids. 80
5.by the debtor to the creditor. However, the formal concept of interest cover anys. 80
6.predictable payoff connected with any kind of debt instrument, whether or nots. 80
7.the payoff is remuneration for the use of capital. Whether or not the payoffs. 80
8.received by the creditor of a discounted bond is compensation for the use ofs. 80
9.capital, for example, it is to be considered as interest as long as it iss. 80
10.predictable. Furthermore, cash flows computed according to the principles. 80
11.amount of a debt instrument and its duration, as well as changes in an inflations. 80
12.index are considered to be interest, although such cash flows are more or lesss. 80
13.unpredictable.s. 80
14.In line with the economic concept of interest, the formal concept of interests. 80
15.states that only payoffs paid by a debtor to a creditor may be considereds. 80
16.interest. Thus if a debt instrument is assigned to a third party, the remunerations. 80
17.paid for the contract is not considered interest; rather it is considered to bes. 80
18.capital gains or losses.s. 80
19.In summary, the formal concept of interest covers any predictable payoffs. 80
20.connected with debt instruments, presupposing that the instrument is nots. 80
21.disposed of. If it is disposed of, the entire payoff is classified as capital gains ors. 80
22.losses. Such a concept is easy to understand and apply, and is primarily ins. 80
23.accordance with the economic concept of interest. However, recent case law ons. 80
24.the income tax treatment of financial instruments has challenged this concept.s. 80
Two Recent Cases
1.A financial instrument that is, in substance, a combination of several basics. 80
2.building block financial instruments, is referred to in this study as a composites. 80
3.contract. Prior to 2001, the taxation of composite contracts was carried out ons. 80
4.a net basis, entailing that in cases in which a debt instrument was implanted in as. 80
5.composite contract – in an index-linked bond, for instance – the predictables. 80
6.payoff connected with the debt instrument was not considered to be interest.s. 80
7.Rather, the payoff was considered as part of the unpredictable net payoff froms. 80
8.68 the composite contract, and, consequently, in principle, it was not possible to separate the payoff from composite contracts and tax some of it as interest.s. 80
9.However, in subsequent case law on composite contracts, the Swedish Supreme Administrative Court has decided that the net payoffs from the financial instruments are to be divided into expected and unexpected payoffs, and that the expected payoff is to be considered interest. In principle, this approach is contrary to previous case law in which composite contracts have been treated as indivisible contracts, only providing one type of income: capital gains. In the new cases, the interest-generating instruments are classified as equity instruments. From these cases, it follows that not only do debt instrument provide interest, but that the payoff from equity instruments other than regular convertible bonds may also be treated as interest.s. 81
10.In principle, the outcome of the two new cases may be understood as a desire on the part of the Supreme Administrative Court to move toward a concept of interest that is more similar to the economic concept of interest. That is, investing capital in a financial instrument entails that the issuer of the instrument has at its disposal the invested capital for the duration of the financial instrument. Therefore, part of the payoff from the investment can be considered as remuneration for the use of the invested capital – that is, interest. If this was the ambition of the Supreme Administrative Court, however, it has not succeeded. When examining the financial instruments dealt with in the cases, it is evident that the payoff that the Supreme Administrative Court has designated as interest is compensation for risk taking; it is a risk premium rather than remuneration for the use of capital.s. 81
11.Another way to interpret the two cases is to consider that the Supreme Administrative Court has moved away from the economic concept of interest. More specifically, the decisive criterion for the classification of income is whether or not it is possible to predict the payoff, or part of the payoff, from an instrument in relation to the principal amount of the instrument.s. 81
12.In my view, the latter interpretation of the two cases is reasonable, but as it is in conflict with prior case law, it constitutes a change in the previous concept of interest. Consequently, interest covers any payoff that is possible for one to compute based on the principle amount of a financial instrument. However, the concept excludes payoffs that are not explicitly separated from the gross cash flow of the instrument. Therefore, the formal concept of interest covers any payoff from a financial instrument that is designated as interest and can be computed based on the principle amount of the financial instrument. 69s. 81
Income Tax Treatment
1.In Section 3.3, it is illustrated that the general structure of the Swedish incomes. 82
2.tax system requires that income from capital management is recognizeds. 82
3.differently than is income generated in a company’s ordinary business. Thiss. 82
4.logic implies that interest from financial instruments held by non-financials. 82
5.companies is to be treated differently than is income generated in the company’ss. 82
6.ordinary business. However, this is not the case. Interest is treated uniformly,s. 82
7.whether it derives form the company’s capital management or ordinary business;s. 82
8.interest is always treated as if it were generated within the ordinary business of as. 82
9.company. As a result, interest expenses are always fully deductible againsts. 82
10.income from capital management, as well as against income from ordinarys. 82
11.business.s. 82
12.The exceptional treatment of interest that is income from capitals. 82
13.management generally gives rise to a major inconsistency in income taxation.s. 82
14.This inconsistency is a result of the connection between Swedish incomes. 82
15.taxation and financial accounting. The accrual recognition of income thiss. 82
16.connection involves entails that all interest attributable to a company is subjects. 82
17.to leveled allocation, over the duration of the interest generating instrument.s. 82
18.Consequently, interest is recognized as an income or an expense, whether or nots. 82
19.the interest is paid. For this reason, the recognition of interest is more similar tos. 82
20.a fair-value approach than to the realization approach, which is the generals. 82
21.approach for recognizing income form a company’s capital management.s. 82
Income from Non-Financial Items
1.In situations in which a financial instrument, such as a derivative, has a non-s. 82
2.financial item as its underlying – for instance, gold – the derivative is treated ass. 82
3.if it were a non-financial item. Thus the income tax treatment of non-financials. 82
4.items is also relevant in relation to financial instruments.s. 82
5.Income from non-financial items is usually treated in the same way ass. 82
6.income from debt instruments is treated. That is, income is treated the sames. 82
7.way as business income, and it is possible to offset expenses or losses againsts. 82
8.any income attributable to the company.s. 82
Expected Income or Expenses and Windfall Gains or Losses
1.In Section 2.2.2.4, Chapter 2, it is argued that, from an economic point of view,s. 82
2.the payoff from financial instruments can be divided into expected income ors. 82
3.70 expenses on the one hand and windfall gains or losses on the other. An expected income or expense is the total payoff of a financial instrument, the value of which has not been subject to any unexpected changes over the duration of the instrument. Thus risk-free instruments provide expected income or expenses. However, if the value of a financial instrument unexpectedly changes, the difference between its expected income/expense and its total payoff is a windfall gain or loss. More specifically, windfall gains or losses are payoffs due to the risk to which an instrument is exposed.s. 82
4.The classification of payoffs into expected income or expenses and windfall gains or losses differs from the legal classification of payoff as presented in this chapter. However, similarities can be identified. In Section 3.4.4.4 in this chapter, the formal (legal) concept of interest is established as the payoff from a financial instrument that is designated to be interest, a payoff that can be computed based on the principle amount of the instrument. Thus the legal concept of interest is similar to what is referred to as expected income or expenses. However, as the legal concept of interest requires payoff to be designated as interest in order to be classified as such, expected income or expenses that are not specifically referred to as interest most likely fall outside the scope of the legal concept of interest. In such cases, expected income or expenses are classified as capital gains or losses. When it comes to windfall gains or losses, it is unlikely that such payoff can be classified as interest, and the payoff is generally classified as capital gains or losses, therefore.s. 83
5.In summary, in many situations the payoff that is designated to be interest is identical to what is referred to as expected income or expenses: the payoffs from most credit-extension instruments, for example. In other situations, expected income or expenses are legally classified as capital gains or losses. As the payoff from capital assets is classified as capital gains or losses in its entirety, for instance, any expected gain or loss from such an asset is covered by that legal classification. Finally, windfall gains or losses are generally referred to as capital gains or losses in the Swedish income tax system.s. 83
Inconsistencies
Tax Arbitrage Opportunities
1.In Section 3.2, I made the point that tax arbitrage opportunities may arise in cases in which two economically equal financial positions are treated differently for income tax purposes. Furthermore, the different treatment is a result of inconsistencies in the income tax system; that is, the payoffs from economically equal investments are treated inconsistently when they are taxed.s. 83
2.The examination of the taxation of income from a company’s capital management illustrates two major inconsistencies in the regulations dealing with such income. First, a distinction is made between capital losses from debt 71s. 83
3.instruments and non-financial items on the one hand, and capital losses froms. 84
4.equity instruments on the other. Second, a distinction is made between incomes. 84
5.classified as interest and capital gains or losses. Whether or not theses. 84
6.inconsistencies provide tax arbitrage opportunities is examined below.s. 84
Debt and Non-financial Items vs. Equity
1.The different tax treatment of capital losses from debt instruments and non-s. 84
2.financial items on the one hand, and capital losses from equity instruments ons. 84
3.the other, entails that it is always as favorable or more favorable to realize a losss. 84
4.from a debt instrument or a non-financial instrument than from a loss from ans. 84
5.equity instrument. This is so because losses from the former type of instrumentss. 84
6.can always be fully set off; whereas losses from equity instrument can only bes. 84
7.set off against gains from equity instruments.s. 84
8.In principle, it is not possible to replicate the economic substance of an assets. 84
9.classified as an equity instrument with an asset classified as a debt instrument ors. 84
10.a non-financial item. Therefore, the inconsistent treatment of capital lossess. 84
11.does not constitute tax arbitrage opportunities as such. However, the inconsistents. 84
12.treatment presents possibilities of utilizing tax benefits in connection withs. 84
13.transactions carried out for the purpose of generating a capital loss. An examples. 84
14.of such a transaction is a straddle transaction, which is dealt with in Sections. 84
15.7.3.3, Chapter 7. It illustrates that a rational tax subject, given the opportunity tos. 84
16.classify a capital loss, will choose to classify it as being derived from either as. 84
17.debt instrument or a non-financial item.s. 84
Interest vs. Capital Gains or Losses
1.The classification of income from capital management as interest or as capitals. 84
2.gains or losses is vital because interest is recognized on the basis of a fair-values. 84
3.approach, whereas capital gains or losses are recognized on the basis of as. 84
4.realization approach. Therefore, in situations in which a tax subject may chooses. 84
5.between classifying income as interest or as capital gains or losses, tax arbitrages. 84
6.opportunities arise.s. 84
7.Tax arbitrage opportunities arising from expected income are classified ins. 84
8.some situations as interest and in other situations as capital gains or losses. Thuss. 84
9.the typical tax arbitrage opportunity arises when two economically equals. 84
10.positions provide expected income, but when the payoff from one position iss. 84
11.classified as interest and the payoff from the other position is simultaneouslys. 84
12.classified as capital gains or losses.s. 84
13.In the examination of the income tax treatment of derivatives and mores. 84
14.complex financial instruments in Chapters 4, 5, 6, and 7, it is illustrated that as. 84
15.rational tax subject will always choose to have income classified as capital gainss. 84
16.rather than interest, and will choose losses/expenses to be classified as interests. 84
17.72 rather than capital losses. This occurs because, in that way, it is possible for the tax subject to utilize a tax credit.s. 84
Conclusions
1.A tax arbitrage opportunity is an opportunity for a tax subject to utilize a tax benefit without acting contrary to the income tax legislation. Such opportunities occur if the payoff from two economically equal positions is treated differently in the income tax system. In such a case, the tax subject has the opportunity to invest in the position that is treated most favorably, and, in that way, the tax subject utilizes the tax benefit.s. 85
2.Regarding financial instruments held by non-financial companies, the Swedish income tax system provides tax arbitrage opportunities by recognizing income in accordance with two different approaches: the realization approach and the fair-value approach. The realization approach generally defers the recognition of income/gains and expenses/losses in comparison with the fairvalue approach. Thus if a rational tax subject has the possibility of choosing whether income/gains are to be recognized in accordance with the realization approach or the fair-value approach, the subject would choose the former. Similarly, in regard to expenses/losses, a rational tax subject would choose recognition in accordance with the fair-value approach. As the tax arbitrage opportunities concern the timing of the income recognition, the arbitrages are generally referred to as timing arbitrages.s. 85
3.In the Swedish income tax system, payoffs from financial instruments held by non-financial companies are, as a general rule, classified as interest or as capital gains or losses. The classification is conducted on the basis of the legal form of the payoff rather than on its economic substance. Accordingly, the income tax system is structured in a way that makes it possible for the payoffs from two economically equal positions to be classified as interest and capital gains/losses, respectively. Furthermore, a payoff classified as interest is recognized on the basis of a fair-value approach, whereas a payoff classified as capital gains or losses is classified on the basis of a realization approach. Consequently, tax arbitrage opportunities occur in situations in which payoff classified as interest has the same economic substance as payoff classified as capital gains or losses. In general, the economic substance of such payoff is referred to as expected income.s. 85
4.Besides the inconsistency in the recognition of payoff classified as interest or as capital gains or losses, the Swedish income tax system is inconsistent in the way capital losses from financial instruments are treated. Whereas capital losses from assets classified as debt instruments or as non-financial items can be fully set off against any taxable income, capital losses from assets classified as equity instruments can be set off only against gains from such instruments. In a situation in which a tax subject wants to recognize a capital loss, the difference 73s. 85
5.in tax treatment entail that a rational tax subject will choose to recognize as. 86
6.capital loss classified as if derived from a debt instrument or a non-financials. 86
7.instrument, rather than classifying it as if it were derived from the disposal of ans. 86
8.equity instrument.s. 86
9.74s. 86
Derivatives
Taxation on the Basis of Legal Form
1.Basic derivative contracts can generally be divided into five groups: forwards, futures, swaps, call options, and put options. These derivatives are traded on a stand-alone basis or are used as components in various financial structures, such as composite contracts or synthetics.s. 87
2.In the Swedish income tax system, the income tax treatment of financial instruments is based on the legal form of the instrument. Derivatives that are used as components in structured financial instruments are usually not treated as stand-alone contracts, but as integrated parts of the financial instruments. Thus such implanted derivatives are, for income tax purposes, different types of contracts than stand-alone derivatives. The income tax treatment of the payoff from implanted derivatives is eventually decided upon the basis of the legal form of the financial instrument in which the derivative is a part. Therefore, when examining the income tax treatment of derivatives, it is necessary to differentiate between stand-alone derivatives and derivatives being implanted in, for example, composite contracts or synthetics. This chapter deals exclusively with the income tax treatment of stand-alone derivatives, whereas the income tax treatment of derivatives implanted in composite contracts, as well as synthetics, are examined in Chapters 5, 6, and 7. Consequently, the term “derivative”, as used in this chapter, is a reference to stand-alone derivatives.s. 87
3.Section 4.2, following this introduction, describes how derivatives are defined according to the Swedish income tax system. As derivatives are taxed on the basis of their legal form, defining these contracts is crucial for income tax purposes. Section 4.3 deals with the income taxation of the payoff from contracts defined as derivatives. The examination is exhaustive, establishing the income tax consequences that any position in a derivative entails. Section 4.4 focuses on the way in which derivatives challenge the Swedish income tax system by providing tax arbitrage situations. The basic principles making it possible to use derivatives in tax-motivated structures are illustrated. Conclusions are presented at the end of the chapter, in Section 4.5. 75s. 87
Defining Derivatives
Derivatives – Financial Instruments or Wagering Contracts?
1.In Section 2.3.1, Chapter 2, a derivative is defined as a financial instrument, thes. 88
2.value of which is derived from the value of an underlying variable, such as ans. 88
3.asset or an index. Furthermore, derivatives generate no value, entailing that thes. 88
4.net payoff of the two positions in a derivative contract is always zero. It appearss. 88
5.in the literature that these characteristics have sometimes prompted writers tos. 88
6.refer to derivatives as wagering contracts. Such a reference is unfortunates. 88
7.because, according to fundamental principles in Swedish contract law, wagerings. 88
8.contracts are considered unethical, and therefore lacking any legal effect. Mores. 88
9.specifically, it is not possible to take legal measures against a party that defaultss. 88
10.the obligations of a wagering contract. Consequently, referring to derivatives ass. 88
11.wagering contracts entails an indirect reference to the (Swedish) derivatives. 88
12.market as anarchical.s. 88
13.However, as noted in Section 2.3.2, Chapter 2, the trade with derivatives. 88
14.financial instruments is conducted in accordance with relatively extensives. 88
15.regulations. The trade with exchange-traded derivatives is conducted ins. 88
16.accordance with the regulations of derivative exchanges; and, in the case ofs. 88
17.tailor-made derivatives, the trade is conducted on the basis of regulatorys. 88
18.documentations established by professional market associations. Consequently,s. 88
19.derivative trade is, as a general rule, connected with contractual regulations thats. 88
20.make it possible for the parties of a derivative to take legal measures against itss. 88
21.counterparty in case of default. Thus unless derivatives are considered to bes. 88
22.unethical contracts in general, it appears from a legal standpoint that derivativess. 88
23.are not to be considered wagering contracts.s. 88
24.The term “derivative” is not used in the Swedish income tax system, buts. 88
25.contracts referred to as derivatives in Chapter 2 are, in the Swedish income taxs. 88
26.legislation, designated to be forwards (terminer), options (optioner), or “similars. 88
27.contracts”. The next section presents a thorough examination of the meaning ofs. 88
28.each of these terms.s. 88
29.76s. 88
Forwards
1.The contents of the expression, “forward” (termin), has not been decided upon in precedent-setting court decisions. Consequently, when establishing the meaning of this term, much attention must be given to the preparatory works of the legislation.s. 89
2.The general meaning of forward (termin) is a reference to forwards as well as future derivative contracts, as they are defined in Chapter 2 of this study. Therefore, the relatively wide scope of the income tax definition of the term is not surprising:s. 89
3.…a contract, suited for public trading, concernings. 89
4.- the purchase of shares, bonds, or other assets at a certain future dates. 89
5.at a fixed price ors. 89
6.- a future settlement, the amount of which is decided upon the basis ofs. 89
7.the value of the underlying asset, an exchange index, or similar.” To be classified as a forward (termin) contract, the definition generally requires that the contract have an underlying, and that it is settled at a future date. Furthermore, it requires the contract to be an obligation for both contracting parties. The contract should also be “suited to public trading”.s. 89
8.The phrase “suited to public trading” replaced the term “financial instrument”, which was a part of the forward (termin) definition until it was discarded from Swedish income tax legislation in 1999. However, the replacement was not intended to change the contents of the definition. Accordingly, the phrase “suited to public trading” generally fulfils the same 77s. 89
9.purpose as the term “financial instrument” did. That is, it excludes regulars. 90
10.purchase or sales contracts from the scope of the definition.s. 90
Options
1.Not until the income tax reform of 1990 was the term “option” defined for thes. 90
2.first time in Swedish income tax legislation. From the preparatory works, its. 90
3.follows that the contents of that definition correspond with the way in which thes. 90
4.term “option” is defined in Section 2.5.1, Chapter 2 of this study: it principallys. 90
5.covers all basic price-insurance derivatives.s. 90
6.The present option definition refers to an option as:s. 90
7.…a right for the holder tos. 90
8.- purchase or sell shares, bonds or other assets at a fixed price ors. 90
9.- receive payments of the amount based on the value of underlyings. 90
10.assets, exchange index, or similar.s. 90
11.The present definition, like the option definition of 1990, covers all types ofs. 90
12.options, whether they are standardized or traded on the OTC market.s. 90
13.A principle difference between an option and a forward is that the formers. 90
14.gives its holder a right to exercise, whereas the latter obliges its holder tos. 90
15.execute the contract. However, in some situations, the right connected with ans. 90
16.option contract is restricted by additional requirements, such as limitations ins. 90
17.terms of exercise or alienation before a certain date. Such options are generallys. 90
18.referred to as employee stock options in the Swedish income tax system.s. 90
19.Consequently, the principal difference between employee stock options ands. 90
20.options within the scope of the income tax definition of “option” is the fact thats. 90
21.options involve an absolute right, whereas the right in an employee stock options. 90
22.is restricted in one way or the other.s. 90
23.78s. 90
24.The right of an option may be challenged not only by contractual obligations, but also by the character of its underlying. An example is real estate as the underlying asset. According to the Swedish Code of Land Law, call options on real estate are not legally binding. It has been established in case law that options with real estate as underlying constitute a different type of contract than do options on chattel such as shares. Thus options having real estate as the underlying are not within the scope of the option definition, as they do not actually involve a right for the holder of the option.s. 91
25.To summarize, the income tax definition of “option” generally covers all basic price-insurance derivatives. However, a contract can never be classified as an option unless it involves an absolute right for its holder to exercise and/or sell it.s. 91
Similar Contracts
1.The joint scope of the forward (termin) and option definitions does not cover all possible variations of derivatives. For example, it appears like most tailor-made price-fixing derivatives are outside the forward (termin) definition. Therefore, a large number of derivatives are most likely to be outside the scope of the definitions and, in principle, treated differently for income tax purposes.s. 91
2.However, when the forward (termin) and option definitions were introduced in 1990, regulations applicable to contracts defined as forwards (terminer) and options were, as a general rule, also applicable to “…other similar liabilities”. 79s. 91
3.The expression “other similar liabilities” is not defined; nor is it discussed in thes. 92
4.preparatory works of the legislation. However, looking at the general reasonings. 92
5.in the preparatory works, the aim of the income tax legislation is uniforms. 92
6.income taxation – that economically comparable transactions are to be treateds. 92
7.equally, regardless of formal differences. Thus the awareness of the rapidlys. 92
8.growing capital market, involving the development of new derivative financials. 92
9.instruments, put pressure on the legislator to create legislation that could meets. 92
10.the future kinds of derivatives and other financial instruments, and tax thes. 92
11.income from these instruments in a uniform way. Considering this, one mays. 92
12.conclude that the legislator used the wording “…options and forwards (termin)s. 92
13.and other similar liabilities...” to increase the judicial discretion, and to leave thes. 92
14.classification of different financial securities to the courts.s. 92
15.In the current income tax legislation, the expression “options and forwardss. 92
16.(termin) and other similar liabilities” has been replaced with “…forwardss. 92
17.(termin), call or put options and similar contracts…” The first draft of thes. 92
18.legislation did not involve “…and similar contracts…”, but referred only tos. 92
19.forwards (termin) and call or put options. In the remittance procedure, it wass. 92
20.argued that such formulation would make it unclear if derivatives not within thes. 92
21.definition of forward (termin) or option would be covered by the scope of thes. 92
22.provision. Consequently, the wording “and similar contracts” was added in thes. 92
23.legislation.s. 92
24.The amendment entails that the judicial discretion within the definitions bes. 92
25.preserved. Consequently, derivatives explicitly covered by the forward (termin)s. 92
26.and option definitions, are, in principle, merely a few examples of all thes. 92
27.derivatives covered by provisions dealing with “similar contracts”. On thes. 92
28.basis of the preparatory works to the legislation, for instance, it can be argueds. 92
29.that swaps are a type of derivative considered as a similar contract.s. 92
Option-Like Contracts
1.To manage the equity of companies, several option-like contracts have beens. 92
2.developed. An example of such a contract is the conversion right, which is as. 92
3.80 right to convert one class of shares to another class: B-shares to A-shares, for example. According to case law, a conversion right is considered to be an option under the Swedish income tax system. However, there are other types of option-like contracts used for equity managements that, for one reason or another, are treated separately from options according to the income tax system. Examples of such contracts are redemption rights and selling rights. These various rights fulfill all the requirements to allow them to be classified as options according to the general option definition, but are treated as independent contracts.s. 92
4.Another example of a basic option, treated separately in the income tax system, is bonus share rights. Whether or not bonus shares rights fulfill all option characteristics has never been decided in case law, but according to the preparatory works, it is likely that they do.s. 93
5.One of the most common option-like contracts developed to manage the equity of a company is the uncovered warrant. The principal difference between a call option on shares and an uncovered warrant is the call option’s existing shares as the underlying; an uncovered warrant, on the other hand, has shares to be issued as the underlying. However, just as in the cases with the other types of option-like contracts, uncovered warrants fulfill all the requirements to allow them to be classified as option.s. 93
6.In several situations, the income tax treatment of options and some of the previously mentioned option-like contracts differ. Thus, hypothetically, the option-like contracts may be subject to two different tax treatments simultaneously. Naturally, this is possible only in theory. However, the hypothetical reasoning triggers the question of whether or not the option-like contracts are covered by the general option definition in a situation in which they are not treated separately, or if they are never to be treated as an option.s. 93
7.In a case on the income tax treatment of uncovered warrants, Justice Hulgaard elaborated on this issue. Hulgaard argued that because uncovered warrants are mentioned separately from options in several provisions of the Swedish income tax act, it cannot have been the intention of the legislator to include uncovered warrants in the option definition. Therefore, the option 81s. 93
8.definition excludes uncovered warrants; instead they are to be treated ass. 94
9.contracts similar to options. Applying Hulgaard’s reasoning on all option-likes. 94
10.contracts subject to separate treatment within the income tax legislation entailss. 94
11.that all such contracts be classified as contracts similar to options – similars. 94
12.contracts – unless explicitly referred to in the legislation. I find this reasoning tos. 94
13.be persuasive, and it constitutes the basis for the treatment of option-likes. 94
14.contracts in this study.s. 94
Taxing Income from Derivatives
Similarities in the Income Tax Treatment of Capital Assets
and Derivatives
1.In principle, gains and losses from the alienation of derivatives held by non-s. 94
2.financial companies are treated as gains and losses from the alienation of capitals. 94
3.assets – as capital gains and capital losses. As capital assets, by definition, ares. 94
4.outside the business of a non-financial company, their values do change, nots. 94
5.because of value-generating activities, but as a result of unexpected changes ins. 94
6.their market value. Being a share, a capital asset typically generates a capitals. 94
7.gain if its market value rises unexpectedly, for example. As the value of capitals. 94
8.assets and derivatives changes on the basis of the same cause – unexpecteds. 94
9.events – a long position in a capital asset is easy to replicate by taking a longs. 94
10.position in a derivative with the capital asset as the underlying variable. Thuss. 94
11.an identical capital gain, as generated by the share, is possible to achieve bys. 94
12.taking a long position in a forward on the share. In order not to facilitate taxs. 94
13.arbitrage opportunities, it is therefore necessary to tax income from derivativess. 94
14.in the same way income from the underlying of the derivative is taxed. This is,s. 94
15.in principle, how the Swedish income tax system works.s. 94
16.Derivatives having an equity instrument or a share index as its underlying is,s. 94
17.for income tax purposes, treated the same way as a stand-alone equitys. 94
18.instrument would be treated. Furthermore, derivatives with a non-financials. 94
19.underlying asset are treated like any capital asset that is not a financials. 94
20.instrument. Following the same pattern, gains and losses from derivatives withs. 94
21.a debt instrument or an interest rate index as its underlying variable is treated ins. 94
22.the same way as capital gains and capital losses from a debt instrument.s. 94
23.Similarly, derivatives having foreign debt instruments or a foreign exchanges. 94
24.82 index, as its underlying variable are treated like stand-alone foreign debt instruments.s. 94
Capital Gains and Capital Losses
1.Capital gains and capital losses are usually computed as the difference between the remuneration of the sold or issued instrument and the cost of obtaining it. Recognition of capital gains and capital losses follows the principle of realization.s. 95
2.When deciding whether a derivative is realized or not, the derivative may be looked upon as an independent instrument or as part of a larger transaction also involving the underlying. If the derivative is considered as an independent instrument, any gains or loss it generates are taxed independently from its underlying. However, in cases in which a derivative is settled by delivery, it may be considered as part of a larger transaction. As such, a derivative is not subject to income taxation, but the value of the derivative is subsumed into the underlying, delivered asset, and taxed when that asset is sold. In the Swedish income tax system, derivatives settled by terms of delivery are not considered to be realized, but as a part in a transaction to purchase or sell the underlying asset. If a derivative is sold, or settled in any way other than through delivery, it is considered to be an independent instrument realized on the day of settlement.s. 95
3.The income tax provisions on capital gains and losses from derivatives focus primarily on derivatives defined as forwards (terminer) or options. Some of these provisions are also applicable to contracts similar to forwards (terminer) and options. However, in other cases, the provisions dealing with forwards (terminer) and options are not applicable to similar contracts. In such cases the general rules on capital gains and losses apply; or in some cases, the legislation does not deal with similar contract at all. In the following section, these various income tax treatments are examined more extensively.s. 95
Forwards[^373]
Disposing of Forwards
1.A forward (termin) that is not subject to clearing can, in principle, be purchased or disposed of any time before it expires. The income tax treatment of gains and losses from the trading of such forwards (terminer) likely follows the general 83s. 95
2.rules on capital gains and capital losses. However, forwards (terminer) subjects. 96
3.to clearing cannot be transferred to another party before they mature. Thus if as. 96
4.company enters into a standardized forward contract, for example, it remains as. 96
5.party to that contract until the contract ceases to exist. If a party to such contracts. 96
6.wants to secure a gain or a loss of the contract, however, it may enter into as. 96
7.reverse position of the contract; it closes out the position before maturity. Ats. 96
8.maturity, the contract is settled either by delivery of the underlying asset or bys. 96
9.cash settlement.s. 96
10.Whether forwards (terminer) subject to clearing are settled by means of as. 96
11.closing out position, by cash settlement, or by delivery, the derivatives ares. 96
12.always held until the day they expire; they are never sold. Therefore, thes. 96
13.provisions on capital gains and capital losses cannot be applied withouts. 96
14.additional rules stating when the derivatives should be considered to be sold.s. 96
15.These rules were established, to a great extent, in a 1990 court decision ons. 96
16.standardized equity index forwards, but are currently stated in the Swedishs. 96
17.Income Tax Act, ITA.s. 96
Closing out Transactions
1.A closing out transaction entails the holder of, for example, a standardizeds. 96
2.forward, securing a gain or a loss by taking an opposite position in an identicals. 96
3.derivative. However, the closing out transaction does not make the derivatives. 96
4.expire, but it will be in the possession of the holder until the maturity of thes. 96
5.contract. Consequently, the holder of the derivative is obliged to exercise it ats. 96
6.maturity. Therefore the disposal of forwards (terminer) subject to clearing iss. 96
7.possible only in connection with cash settlement, or delivery, at maturity of thes. 96
8.contracts.s. 96
Disposal by Cash Settlement or Delivery
1.The Swedish ITA explicitly states that any forward (termin) that is settled net ins. 96
2.cash is to be consider disposed of by both contracting parties. Consequently,s. 96
3.forwards (terminer) with indexes as the underlying variable (e.g. foreigns. 96
4.exchange derivatives) are always considered to be disposed of at the maturity ofs. 96
5.the contract.s. 96
6.Concerning the income tax treatment of price-fixing derivatives settled bys. 96
7.terms of delivery, a difference is made between forwards (terminer) ands. 96
8.contracts similar to forwards (terminer). If a forward (termin) is settled by termss. 96
9.84 of delivery, it is not to be considered as sold. A short position in a forward (termin) contract settled by terms of delivery is not subject to any income tax action, but when the underlying is delivered, it is the delivery price of the forward that constitutes the remuneration for disposing of the underlying asset. A long position in a forward (termin) settled by terms of delivery, entails that the delivery price of the forward is transferred to the underlying and constitutes its cost of obtaining when it is being disposed of at a future date. Consequently, the forward (termin) does not actually cause any income tax consequences.s. 96
10.How to deal with contracts similar to forwards (terminer) settled by terms of delivery is not stated in the legislation. Thus in principle, such derivatives are not subject to taxation. However, when the underlying asset of the derivative is delivered, the value of the derivative is, in principle, transferred to the parties by means of the delivered asset. In cases in which the derivative has a value at inception, it is likely that any payments related to entering into the contract are subsumed into the exercise price or the cost of obtaining the delivered asset. Consequently, the effects of the transaction are, in practice, similar to the effects resulting from the legislation dealing with forwards (terminer).s. 97
11.The reason for making a distinction between forwards (terminer) and contracts similar to forwards (terminer) is not perfectly clear. As it seems to have no practical effects; however, I leave this issue without further comment.s. 97
The Cost of Obtaining
1.Establishing the cost of obtaining a forward (termin) is relatively uncomplicated. The character of the contract implies that its value is always zero at inception; thus in principle, there are no costs when obtaining a forward (termin) contract. However, contracts similar to forwards (terminer), such as tailor-made forwards, can be constructed in a way that gives them a value at inception. It is likely that the drafting of such a contract is connected with additional expenses. Similarly, additional expenses may occur when entering into exchange-traded derivatives. In any case, expenses related to entering into a price-fixing derivative are likely considered to be the cost of obtaining the derivative.s. 97
2.If forwards (terminer) are to be treated as equity instruments or debt instruments, the averaging method is applicable when computing the cost of obtaining the derivative contracts. This method requires that the average 85s. 97
3.purchase price of the derivatives be considered the price of the contracts if thes. 98
4.same type of derivative is purchased at different prices.s. 98
Recognition of Gains and Losses
1.The taxation of capital gains and losses generally follows the principle ofs. 98
2.realization, entailing that capital gains are to be taxed in the period during whichs. 98
3.they occur and that capital losses are deductible when they are definite. Thes. 98
4.principle of realization is mirrored in the income tax treatment of forwardss. 98
5.(terminer). As forwards (terminer) are considered to be disposed of the day theys. 98
6.are settled –at the maturity of the contract – the income taxation of gains ands. 98
7.losses is conducted during the period in which they are settled or cease to exist –s. 98
8.when they are sold.s. 98
Losses
1.The Swedish income tax system treats losses from forwards (terminer)s. 98
2.differentially, depending on the underlying of the derivative. Generally, capitals. 98
3.losses from derivatives are treated the same way as capital losses from assets ofs. 98
4.the same type as the underlying asset of the derivative. Thus losses froms. 98
5.derivatives with equity as their underlying can be offset only by gains froms. 98
6.equity instruments; whereas losses from derivatives with any underlying others. 98
7.than equity can be offset by company income. The differences in income taxs. 98
8.treatment among the various assets are examined in greater depth in Sections. 98
9.3.4.2.2, Chapter 3.s. 98
Short Selling
1.Short selling is a transaction similar to a position in a forward (termin).s. 98
2.Therefore, although not a forward (termin) by definition, the income taxs. 98
3.treatment of short-selling transactions are examined in this section.s. 98
4.Short selling principally entails that a company borrow an asset of anothers. 98
5.party and sell it to a third party. The company lending the asset is compensateds. 98
6.by means of interest. On a specific future date, the borrowing companys. 98
7.repurchases the asset and returns it to the party from which it was originallys. 98
8.borrowed. If the price of the asset has decreased when returned to its originals. 98
9.owner, the company conducting the short selling typically makes a gain. Ins. 98
10.principle, the only difference between a short-selling transaction and a shorts. 98
11.position in a forward (termin) is that the short-selling transaction contains thes. 98
12.86 lending and delivery of assets at the inception of the transaction. However, this difference elicits a tax treatment that differs from the tax treatment of forwards.s. 98
13.When a company relinquishes its right to dispose an asset and transfer it to another party, the asset is generally considered to be sold. Thus short selling usually means that the party lending the asset is considered to be selling it, and the party borrowing the asset is considered to be purchasing it. Likewise, when the asset is returned, the party returning the asset is considered to be selling it and the party receiving the asset is considered to be purchasing it. Consequently, parties lending an asset in a short-selling transaction must recognize a capital gain in the income period during which they lend the asset. Thus besides receiving some interest, there are no incentives to lend assets to someone planning to carry out a short-selling transaction; thus the possibility of conducting such transactions are usually limited. However, short selling is considered propitious for the liquidity of the market in which the underlying is traded. Therefore, special provisions on the short selling of equity instruments and debt instruments have been introduced in the Swedish income tax legislation.s. 99
14.The special provisions establish that if an equity instrument or a debt instrument has been lent for purposes of short selling, it is not to be considered sold. Furthermore, when a borrowed equity instrument or debt instrument is sold to a third party, the remuneration from that sale is not taxed until the borrowed asset is returned to its original owner. However, the special provision presupposes that the assets are returned within a year from the date they are disposed of to a third party. Furthermore, the provision is applicable only in situations in which the borrowing party does not own the type of asset it borrows.s. 99
15.In summary, the income tax legislation limits the possibilities for conducting short-selling transactions on assets other than those classified as equity instruments and debt instruments. In a short-selling transaction on equity instruments or debt instruments, the party borrowing the asset is usually not subject to taxation until the borrowed asset is returned, and the party lending the asset is, in regard to the short-selling transaction, subject to no taxation other than the taxation of interest. Consequently, the taxation of assets disposed of by a short-selling transaction is equal to the taxation of assets disposed of by means of a forward (termin). 87s. 99
Options[^403]
Disposing of Options
1.The parties of an option have different contractual positions: the party in a longs. 100
2.position has a right, whereas the party in a short position is obliged to fulfill thes. 100
3.contract if the other party so wishes. Therefore, the option is considered to bes. 100
4.in the possession of the party having the long position in the contract.s. 100
5.Consequently, it is only the party having a long position in the option that cans. 100
6.sell the contract. However, just as in the case of forwards (terminer), boths. 100
7.parties of an option have the possibility of closing out their positions by enterings. 100
8.into an opposite contract.s. 100
9.Options may be settled net in cash or by delivery of the underlying.s. 100
10.Moreover, it is possible to dispose of options not subject to clearing before theirs. 100
11.maturity. Finally, if an option has no value – if it is out of the money – thes. 100
12.holder of the derivative may choose not to exercise it. Consequently, in additions. 100
13.to the settlements of forwards (terminer), an option may be “settled” simply bys. 100
14.neglecting to exercise it.s. 100
15.Similar to the rules on the income tax treatment of forwards (terminer), thes. 100
16.rules about how to treat gains and losses from options were, in principle,s. 100
17.established in a number of precedent-setting court decisions from the 1980s.s. 100
18.These rules are examined in the next section.s. 100
Disposal by Cash Settlement or by Neglecting Exercise
1.The possibility of exercising an option is eventually dependent on the type ofs. 100
2.option. Whereas European options can be exercised only at maturity, Americans. 100
3.options can be exercised any day until maturity, and the possibility ofs. 100
4.structuring the exercise possibilities for exotic options are limitless.s. 100
5.Disregarding the exercise possibilities for exotic options, which cannot bes. 100
6.systemized, the exercise possibilities for European options and Americans. 100
7.options do differ.s. 100
8.An American option can be settled net in cash any time during its lifetime;s. 100
9.and once settled, it is considered as sold. Because cash settlement of Europeans. 100
10.options cannot be carried out until the maturity of the contract, the option is, ins. 100
11.principle, not possible to dispose of if not sold to another party. However, justs. 100
12.88 like forwards (terminer) that are settled net in cash, European options are considered disposed of when they are subject to cash settlement at maturity.s. 100
13.Furthermore, options that are held to maturity without being exercised are considered to be disposed of at maturity. It is pertinent to note that it is only possible to dispose of options that are considered independent instruments. In a precedent-setting court decision, it was stated that an option used as an interestrate guarantee connected to a future debt instrument was lacking independence to such an extent that it could not be considered disposed of when its duration expired.s. 101
14.Finally, if the conditions of an option essentially change, the option is to be considered sold. An example of such change occurs when the duration of an option is extended. It has been established in case law that whether or not the exercise price of an option is adjusted in order to maintain the value of an option because of extended duration, an extended duration is such a vital change in the condition of an option that the option must be considered to be sold.s. 101
The Disposal of Options Settled by Delivery
1.When an option is settled by delivery, it is not considered to be sold. Possible gains and losses from such options are incurred on the underlying asset, and taxed when that asset is sold.s. 101
2.Derivative contracts similar to options are left without notice by the income tax legislation. However, the value of the derivatives are, in practice, transferred to the delivered, underlying asset; and the actual income tax consequences are therefore identical to that of options.s. 101
Disposing of Options by Transferring Them to Another Party
1.Although most options are subject to clearing, and thus not tradable between two independent parties, tailor-made options can be traded. When options are traded, any gain or loss from such transactions is taxed in accordance with the general provisions on capital gains and capital losses.s. 101
The Cost of Obtaining
1.The cost of obtaining an option is the price paid – generally its premium. In cases in which options are to be treated as equity instruments or debt 89s. 101
2.instruments, the averaging method is applicable when establishing the cost ofs. 102
3.obtaining the derivatives subject for disposal.s. 102
Recognition of Gains and Losses
1.The gain or loss of a long position in an option is the difference between thes. 102
2.premium, which is negative, and the amount received when the derivative iss. 102
3.sold. The gains and losses from a short position of an option are computeds. 102
4.opposite to long positions. That is, if the received premium is greater than as. 102
5.possible amount paid when the derivative is settled, the issuer of the options. 102
6.receives a gain. In other cases, the short position involves a loss.s. 102
7.For a party that has a long position in an option, the premium of the contracts. 102
8.is considered to be the price for obtaining the derivative. Therefore, the payments. 102
9.has no income tax consequences until the gain or loss of the derivative iss. 102
10.computed – in principle at maturity of the contract, or, in the case of delivery,s. 102
11.when the underlying of the derivative is sold. Thus following the general ruless. 102
12.on capital gains and capital losses, the net payoff from the derivative is taxed ats. 102
13.realization.s. 102
14.For the party in a short position of an option, the premium constitutess. 102
15.remuneration for the issued derivative. Thus in principle, the derivative iss. 102
16.realized and the remuneration is to be taxed immediately. However, if thes. 102
17.derivative is exercised, the net gain of the short position is reduced or evens. 102
18.turned into a loss. In such cases the negative payoff is usually taxeds. 102
19.immediately, that is, at realization. Consequently, if the duration of an options. 102
20.covers more than one income period, the party in a short position generally hass. 102
21.to recognize the gain (the premium) and loss (the negative payoff occurring ifs. 102
22.the derivative is exercised) from the derivative in different income taxs. 102
23.periods.s. 102
24.However, there is an exception to the general rule. The income tax reform ofs. 102
25.1990 made a change in which options suited to public trading, and withs. 102
26.durations of less than one year were to be treated differently than other options,s. 102
27.insofar as the taxation of the party involved in a short position of thes. 102
28.derivative. These provisions are still valid. For options settled net in cash, thes. 102
29.provisions state that if a party issues an option suited to public trading, and withs. 102
30.a duration of less than one year, the premium is taxed at maturity of thes. 102
31.90 option. In all other cases, the premium is taxed immediately, in accordance with the general rule.s. 102
32.When an option suited to public trading and with duration of less than one year is settled by terms of delivery, the party having a short position in that contract is allowed to defer the taxation of the premium until the result of the underlying asset is taxed. Furthermore, a premium received for issuing put options suited to public trading operative for more than one year, and with the possibility of exercising before maturity (e.g. an American option) is considered to be part of the cost of obtaining the underlying of the option in cases in which the derivative is exercised the same year it is issued. Similarly, the premium received when issuing a call option suited to public trading, operative for more than one year, and with the possibility of exercising before maturity is considered to be part of the remuneration when disposing of the underlying of the option – presupposing that the derivative is exercised in the same income period it is issued.s. 103
33.In summary, the premium paid to obtain a long position in an option can be offset at the maturity of the derivative, or in the case of settlement by terms of delivery, when the underlying is sold. However, the income tax treatment of the premium received by the party in a short position of an option is more complicated. Generally if the derivative is an option suited to public trading, and with duration of less than one year, the taxation of the premium is deferred until the option is settled. In any other case, the premium is taxed immediately, and any possible negative payoff that may occur when the derivative is exercised is taxed when the result of the derivative transaction is definite.s. 103
Offsetting Losses
1.The treatment of capital losses from options is decided on the basis of the character of the underlying of the option. Because these different tax treatments are examined in Section 3.4.2.2, Chapter 3, the issue is not discussed further here.s. 103
Option-Like Contracts
1.The option-like contracts dealt with in Section 4.2.5 differ from regular options in that they are always settled by delivery. Similar to forwards (terminer) and options, when an option-like contract is settled by delivery, any gain or loss of the contract is subsumed into the underlying asset and taxed when that asset is 91s. 103
2.realized. However, it is possible in many situations to sell the option-likes. 104
3.contracts – to dispose of them before maturity. In such a case, the gain of thes. 104
4.contract is computed in accordance with the general rules on capital gains ands. 104
5.capital losses: as the difference between the remuneration of the sold contracts. 104
6.and the cost of obtaining it.s. 104
7.Option-like contracts such as redemption rights and selling rights ares. 104
8.generally issued to the shareholders of the issuing company, meaning that suchs. 104
9.contracts are initially obtained because of the holding of specific shares.s. 104
10.Therefore, the cost of obtaining the option-like contract may usually bes. 104
11.computed on the basis of the value of those shares. Although applicable ins. 104
12.theory, such computation is not used because it is complicated and costly for thes. 104
13.public authorities. Thus the cost of obtaining redemption rights, selling rights,s. 104
14.bonus share rights, or uncovered warrant are always to be considered zero ins. 104
15.cases in which the option-like contract is obtained as a result of the holding ofs. 104
16.shares of the issuing company. However, if such a right is obtained in somes. 104
17.other way – purchased from another party, for instance – the general rules ons. 104
18.capital gains and capital losses are applicable.s. 104
Derivatives with the Issuing Company’s Own Shares as the
Underlying
1.According to Swedish company law, publicly listed companies may purchases. 104
2.their own shares under certain conditions. Such purchases may be made fors. 104
3.purposes of constructing or hedging employee stock option schemes or fors. 104
4.purposes of managing equity. The gains and losses a company may receive froms. 104
5.the dispose of its own shares or from the dispose of options, forwards (termin),s. 104
6.or similar contracts with its own shares as the underlying, are tax exempt.s. 104
7.Furthermore, gains and losses from the dispose of shares from a parent companys. 104
8.or derivatives with shares from a parent company as the underlying are taxs. 104
9.exempt. It is immaterial whether or not the company’s own shares exist whens. 104
10.the derivative is disposed of or if the shares are to be issued; no difference iss. 104
11.made between covered and uncovered warrants with a company’s own shares ass. 104
12.the underlying asset.s. 104
13.92s. 104
Derivatives and Tax Arbitrage
Tax Arbitrage Opportunities
1.The income tax treatment of capital gains or losses, and interest, differs in the sense that the former type of payoff is recognized on the basis of realization, whereas interest is taxed on an accrual basis – on the basis of a fair-value approach. It is noted in Section 3.2.5, Chapter 3 that the use of two different approaches for income recognition in the Swedish income tax system gives rise to tax arbitrage opportunities – more specifically timing arbitrages. These arbitrage opportunities generally occur when two economically equal financial positions are given different legal forms, and the payoff from the positions are classified on the basis of the legal form of the position. From the examination of the income tax treatment of derivatives conducted in this chapter, it follows that the payoff from these instruments is always taxed as capital gains or losses. Therefore, in a situation in which the economic substance of a derivative and a typically interest-paying instrument such as a bond is similar, timing arbitrage opportunities exist.s. 105
2.These tax arbitrage opportunities can generally be divided into two categories. First, tax arbitrage opportunities exist in situations in which derivatives constitute or are part of hybrid instruments. Second, arbitrage situations may be utilized by using derivatives to create synthetic instruments. The significance of hybrid and synthetic instruments is presented next.s. 105
Hybrid Instruments and Synthetic Instruments
1.In this study, a hybrid instrument is a legally distinct contract, providing expected income as well as windfall gains and losses. Because expected income is, in principle, taxed as interest, and because windfall gains are, in principle, taxed as capital gains, the taxation of the payoffs from hybrid instruments should, theoretically, be taxed as part interest and part capital gains. However, this is not always the case. As a general rule, the payoff from a legally distinct capital investment is taxed as one, single type of income. Thus the payoffs from hybrid instruments are generally taxed either as interest, or as capital gains or losses. For example, in a situation in which a derivative contract constitutes a hybrid instrument, its entire payoff is taxed as a capital gain.s. 105
2.A synthetic instrument is a combination of long and short positions in legally distinct financial instruments that provide a net payoff equal or similar to the payoff from another, legally distinct financial instrument: the replicated 93s. 105
3.instrument. If the payoff of the replicated instrument is classified as interest –s. 106
4.in the case of a bond, for instance – and the payoff of the building blocks of thes. 106
5.synthetic instrument is classified as capital gains or losses, tax arbitrages. 106
6.opportunities exist.s. 106
7.The following two subsections examine the way in which derivatives may bes. 106
8.used as hybrid instruments or as synthetic instruments in order to create taxs. 106
9.arbitrages opportunities.s. 106
Derivatives as Hybrid Contracts
Compensation for the Advance of Capital
1.Section 2.6.2.2, Chapter 2, makes the point that the payoff from credit-extensions. 106
2.instruments such as bonds is compensation for the advance of capital.s. 106
3.Furthermore, compensation for the advance of capital is, as a general rule,s. 106
4.expected income, as credit-extension instruments are usually exposed to lows. 106
5.risk. Thus from an economic point of view it can be concluded that the advances. 106
6.of capital pays expected income.s. 106
7.On the basis of this conclusion, it is possible to argue that any capitals. 106
8.investment entailing the advance of capital at inception generates expecteds. 106
9.income. Thus if derivatives, which typically generate windfall gains or losses,s. 106
10.involve the advance of capital at inception, the payoff of the derivative is, ins. 106
11.part, expected income. More specifically, a derivative that entails the advance ofs. 106
12.capital at inception is typically a hybrid instrument. The simplest example ofs. 106
13.such a hybrid derivative is a basic European option: a plain vanilla option.s. 106
Plain Vanilla Options
1.The forward price of an option is generally its spot price at inception plus itss. 106
2.cost of carry until maturity. Because the cost of carry of an option is, ins. 106
3.principle, limited to the cost of capital, the forward price of an option can bes. 106
4.established on the basis of a risk-free interest rate and the premium of thes. 106
5.option. That is, the forward price of an option equals the premium of the options. 106
6.capitalized with the risk-free interest rate until maturity. Consequently, if thes. 106
7.premium of a two-year European put option is 100, and the risk-free interest rates. 106
8.is 5 percent, the two-year forward price of the put option is 110.52. Thes. 106
9.difference between the spot price and the forward price represents expecteds. 106
10.income for the party in a long position and an expected expense for the party ins. 106
11.a short position, as illustrated by the following example.s. 106
12.94s. 106
13.Example:s. 107
14.Company A acquires a European put option from Company B for thes. 107
15.disposal of 100 shares in three years at a price of 10 per share. The prices. 107
16.of the option is 50. At a risk-free interest rate of 5 percent, the forwards. 107
17.price of the right to dispose of the shares is 58.1. The differences. 107
18.between the spot price and the forward price (8.1) represents expecteds. 107
19.income for Company A and an expected expense for Company B.s. 107
20.If the spot price of the underlying is 9 at maturity of the option,s. 107
21.Company A will realize an unexpected gain of 41.9.Consequently, ofs. 107
22.the 100 Company A receives at maturity of the option, 50 ares. 107
23.reimbursement, 8.1 are expected income, and 41.9 represent a windfalls. 107
24.gain. Similarly, of the 100 paid by Company B at maturity of the contract,s. 107
25.50 are the repayment of the capital designated to be premium, 8.1 are ans. 107
26.expected expense, and 42.12 represent a windfall loss.s. 107
27.If the spot price of the underlying shares is 11 at maturity of the option,s. 107
28.the option will not be exercised. Company A will realize a windfall losss. 107
29.of 58.1, and Company B will realize a corresponding windfall gain.s. 107
Options that are “Deep-in-the-Money”
1.As illustrated in the previous section, the relationship between spot prices and forward prices entails that options can be considered hybrid contracts providing expected income or expenses as well as windfall gains or losses. However, because the value of options primarily depends on unexpected events, the majority of the payoffs from these contracts are windfall gains or losses. It is generally risky, therefore, to invest capital in options. However, it is possible to structure options, making their payoffs close to a risk-free investment. If the underlying of the option is close to risk free, and the option has a great intrinsic value at inception – is issued deep-in-the-money – the contract is, as illustrated by the following example, similar to a bond.s. 107
2.Example:s. 107
3.Company A acquires a European call option from Company B for thes. 107
4.purchase of 100 units of a commodity in three years at a price of 8.38s. 107
5.per unit. Company A pays Company B 1000 for the option. 95s. 107
6.With a risk-free interest rate of 5 percent, Company A expects ans. 108
7.income of 161.8 and Company B expects an equivalent expense. Ats. 108
8.the maturity of the contract, the spot price of the underlying asset is 20.s. 108
9.Consequently, Company A exercises the option by cash settlement ands. 108
10.receives 1162 from Company B. The 1162 consists of repayment ofs. 108
11.the “premium” (1000), expected income (161.8), and a windfall gains. 108
12.(0.2).s. 108
13.By setting the strike price of the option in a way that makes the option deep-in-s. 108
14.the-money, the premium paid for the option become relatively large.s. 108
15.Consequently, by structuring an option deep-in-the-money, it is possible tos. 108
16.advance capital from the party in a long position of the option comparable to thes. 108
17.advance of capital when taking a long position in a bond. Similarly, if the assets. 108
18.underlying the option is close to risk free, the option can be structured to provides. 108
19.a payoff similar to a bond. Whereas the payoff from a bond is taxed as interest;s. 108
20.on an accrual basis, the payoff from a long position in an option is taxed on thes. 108
21.basis of realization. Thus the deep-in-the-money option provides a tax arbitrages. 108
22.opportunity.s. 108
Taxing the Payoffs from Options and Bonds
1.As illustrated in the previous section, an option can be structured in a way thats. 108
2.makes its payoff similar to the payoff from a bond with the same principles. 108
3.amount as the premium of the option. Consequently, the two investments haves. 108
4.similar economic substance. As the payoff from an option is taxed on the basiss. 108
5.of realization and the payoff from a bond is taxed when it accrues, it is, from ans. 108
6.income tax perspective, more favorable to take a long position in the option thans. 108
7.to take a long position in the bond. It is not readily apparent, however, if it iss. 108
8.more favorable to take a short position in the option or a short position in thes. 108
9.bond.s. 108
10.The party in a short position of the option must recognize the receiveds. 108
11.premium as a capital gain the same income year it is paid. Furthermore, whens. 108
12.the option is exercised, a capital loss corresponding to the value of the option –s. 108
13.the premium plus the expected expense and windfall loss – is recognized.s. 108
14.Thus in general, the short position in the option is less favorable than a shorts. 108
15.position in a bond, because the capital gain is taxed at inception of the contracts. 108
16.and the possibility to offset the capital loss, recognized at maturity of thes. 108
17.contract, may be limited.s. 108
18.96s. 108
19.However, the party being in a short position of the option may be a preferred tax subject, or may be in a position that makes it possible to use the capital gain to utilize loss carry forwards, and/or to offset the capital losses. In such cases, it is possible that the short position in the option contract is more favorable than the short position in a bond. Consequently, it is not possible to come to any general conclusions concerning the tax efficiency of the short position in the option.s. 109
Prepaid Forward
1.As noted in previous section, the payoff of a long position in a deep-in-themoney call option is more favorably taxed than is the payoff of a long position in a bond. It is uncertain, however, if the taxation of the payoff of a short position in such an option is more favorable than a short position in a corresponding bond. Consequently, the possibility of taking a long position in such options may be limited. In such cases, it is possible to reach the same financial position by entering into a long position in a cash settled, prepaid forward.s. 109
2.On the basis of a no-arbitrage assumption, the exercise price of a forward is the forward price of the underlying of the derivative. If the spot price of an asset is 1000 and the risk free interest rate is 5 percent, for instance, the exercise price of a three-year forward contract on the asset is 1161.8. If the party in a long position of such contract – Company A – prepays the exercise price at inception, it must pay an amount equal to the spot price of the underlying asset: 1000. At the maturity of the contract, the party in a short position – Company B – pays an amount equal to the spot price of the underlying asset. If the spot price of the underlying asset is 1170 at the maturity of the contract, for instance, Company B must transfer 1170 to Company A. The payment is, in essence, a repayment of the principle amount (1000), expected income (161.8), and a windfall gain (8.2).s. 109
3.The fact that a forward contract is prepaid does not appear to influence its income tax character as a forward (termin). Thus the income tax treatment of a prepaid forward is similar to a regular forward (termin) contract or a contract similar to a forward (termin). Consequently, at the maturity of the contract, Company A recognizes a capital gain of 170 and Company B recognizes a corresponding capital loss.s. 109
4.The income tax treatment of prepaid forwards entails that the party in a long position can defer taxation of the expected income in the same way as a party having a long position in the call option above. That is, the income tax treatment is more favorable in this situation than in a long position in a bond. However, 97s. 109
5.the party in a short position is, in principle, treated less favorably than a party ins. 110
6.a short position in a bond. This is so because the loss of the short forward cannots. 110
7.be offset until the contract matures. Furthermore, the possibility to offset the losss. 110
8.may be restricted.s. 110
9.In the case of a prepaid forward, and a deep-in-the-money call option, boths. 110
10.parties of the contract must agree on structuring the contracts in a way thats. 110
11.makes its payoff similar to that of a bond. Because the short positions in theses. 110
12.contracts are, in principle, less favorably treated for income tax purposes thans. 110
13.are financially equal positions in a bond, however, the availability of theses. 110
14.contracts may be limited. In such cases, the same financial position and the sames. 110
15.preferred income tax treatment can be achieved by using derivatives to take as. 110
16.long position in a synthetic bond. How this may be accomplished is furthers. 110
17.presented in the next section.s. 110
Using Derivatives in Synthetic Instruments
1.A synthetic instrument is a portfolio consisting of long and short positions ins. 110
2.different financial instruments; the payoffs offset each other, making the nets. 110
3.payoff of the portfolio similar or identical to the payoff from another, singles. 110
4.financial instrument. Because the deep-in-the-money option and the prepaids. 110
5.forward, above, are single financial instruments, they are not to be considereds. 110
6.synthetic bonds, although they replicate the payoff from a bond. Furthermore,s. 110
7.although the payoffs of the building blocks of a synthetic instrument may bes. 110
8.expected income and windfall gains or losses, the net payoff of the combinations. 110
9.could either be expected income or windfall gains or losses. Therefore, synthetics. 110
10.instruments are not necessarily hybrid instruments. Just as in the case of thes. 110
11.hybrid instruments, however, synthetic instruments are constructed on the basiss. 110
12.of a no-arbitrage assumption.s. 110
13.In Section 2.6.3.4, Chapter 2 a synthetic bond is created by a long position ins. 110
14.shares and a short position in a forward on the shares. The similarity betweens. 110
15.such investments and a long position in a bond can be illustrated as follows: As. 110
16.long position in a bond entails the advance of capital to the bond issuer. In as. 110
17.synthetic bond, the same amount of capital is invested in shares (or any others. 110
18.underlying). Moreover, a long position in a bond entails expected income,s. 110
19.computed on the basis of the principle amount of the bond. For a synthetic bond,s. 110
20.expected income is the difference between the spot price of the shares, and thes. 110
21.delivery price of the forward. As the delivery price is the forward price of thes. 110
22.shares at the inception of the contract, the expected income of the synthetic bonds. 110
23.is identical to the expected income of the bond, presupposing the forward prices. 110
24.has been computed on the basis of the same interest rate as stated in the bond.s. 110
25.98s. 110
26.The income tax treatment of the synthetic bond is generally more favorable than the income tax treatment of a real bond. This is so because the expected income from the bond is taxed as interest, on an accrual basis, whereas the expected income from the synthetic bond is taxed as capital gains on the basis of realization. Furthermore, as a synthetic instrument consists of positions in more than one financial instrument, there is not necessarily one single counterpart to the synthetic instrument. Therefore, when examining the income tax treatment of a synthetic instrument, it is only the replicated position that is relevant to benchmark.s. 111
27.Instead of entering into a short position in a forward contract, it is equally good to take a long position in a put option and simultaneously issue a call option with the same underlying asset, duration, and strike price as the put option. Such combinations of options are generally known as “married putand-call options”. The similarity between the two positions can be illustrated in the following way: If the exercise price of the forward is the same as the strike prices of the married put-and-call options, the value of the short forward and the long put option will increase if the spot price of the underlying falls below the exercise price/strike price. Similarly, the value of the short forward and the short call option will decrease if the spot price of the underlying rises above the exercise price/strike price.s. 111
28.LP + SC = SFs. 111
Figure 4.1 To structure a synthetic forward
1.The payoffs from a long put option (LP) and a short call option (SC) equal the payoff from a short forward (SF): a synthetic forward. The vertical arrows represent the payoff of the derivatives, and the horizontal arrows represent changes in the value of their underlying. 99s. 111
2.The income tax treatment of a synthetic bond, consisting of married options ands. 112
3.a long position in their underlying, is more favorable than is the income taxs. 112
4.treatment of a real bond. This is so because the premium received whens. 112
5.issuing the call option can be offset by the premium paid for the long position ins. 112
6.the put option; therefore no taxes are paid at inception of the synthetic bond. Ats. 112
7.the maturity of the synthetic bond, the options and the shares are disposed of,s. 112
8.and their respective payoff is taxed as capital gains or capital losses on the basiss. 112
9.of realization. It is important, however, to ensure that the capital losses in thes. 112
10.synthetic can be offset fully against its capital gains.s. 112
Expected-Return Taxation
1.The tax arbitrage opportunities presented in Sections 4.4.3 and 4.4.4 principallys. 112
2.occur as a result of the payoff from two economically equal financial positionss. 112
3.being treated differently for income tax purposes. For example, expected incomes. 112
4.from a derivative is always classified and taxed as a capital gain or loss; whereass. 112
5.expected income from a bond, as a general rule, is classified and taxed ass. 112
6.interest. Consequently, in order to prevent the tax arbitrage opportunities, its. 112
7.seems necessary to disregard the legal classification of the payoffs form thes. 112
8.financial positions, and to tax the payoff on the basis of its economic character.s. 112
9.More specifically, the taxation could be carried out on the basis of whether thes. 112
10.payoff is expected income or expenses or if it is windfall gains or losses. In thes. 112
11.tax literature, this type of taxation is generally referred to as expected-returns. 112
12.taxation or expected value taxation.s. 112
13.Introducing taxation on the basis of expected income or expenses ands. 112
14.windfall gains or losses, as a method of preventing certain tax arbitrages. 112
15.opportunities in the Swedish income tax system would likely be extremelys. 112
16.effective. However, as previously mentioned, such taxation is carried outs. 112
17.irrespective of the legal form of the income. Furthermore, it involves the party tos. 112
18.disregard the legal classification of the instruments providing the payoff.s. 112
19.Whether expected income is designated to be interest or capital gains, fors. 112
20.instance, is immaterial. Similarly, whether the instrument providing the payoff iss. 112
21.classified as debt or equity is of no importance. Consequently, implementings. 112
22.expected-income taxation in the Swedish income tax system would requires. 112
23.major changes of the tax system. Therefore, such taxation may be considereds. 112
24.100 unrealistic as a method of preventing tax arbitrages related to derivatives and other financial instruments.s. 112
Conclusions
1.The main purpose of this chapter is to reach conclusions on the ways in which stand-alone derivatives are treated under the Swedish income tax system, and if the treatment enables tax arbitrage. This chapter makes a critical point: The income tax treatment of derivatives is carried out on the basis of the legal form of the contract, rather than on the payoff from a derivative being expected or unexpected. Consequently, the income tax definition of derivatives is imperative.s. 113
2.The term “derivative” is not used in the income tax system, but references are made using the terms “forwards (termin)” and “options”. Moreover, because these terms do not cover all types of derivatives, they are supplemented by the expression “similar contracts” that, in principle, cover all derivatives not covered by the forward (termin) and option definitions. The relatively extensive room for judicial discretion provided by the expression “similar contracts” seems reasonable to prevent certain tax arbitrage opportunities. For example, although the forward (termin) definition likely excludes a large number of tailormade price-fixing derivatives, such derivatives are considered to be similar to forwards (terminer) and thus treated the same way as if they were covered by that term. Consequently, it is not possible to circumvent the legislation by replicating a standardized forward by means of a tailor-made forward Moreover, because new variations of derivative contracts are constantly being developed, certain room for judicial discretion in relation to the forward (termin) and option definitions is necessary in order to keep the legislation relevant.s. 113
3.This chapter explains how the payoff from any contract defined as an option, a forward (termin), or a similar contract is taxed. The income tax provisions dealing with derivatives could be considered relatively complex. They are scattered in several different chapters of the Swedish ITA, and within these chapters they appear in different places. However, when applying the rules, the income tax treatment is relatively straightforward. Gains and losses are generally computed as the difference between the exercise price and the cost of purchasing the contract, in accordance with the general rules on capital gains and capital losses. Furthermore, the recognition of gains and losses follows the general principles applicable to capital gains and capital losses: the principle of realization. Finally, when it comes to treating losses from derivatives, there are no differences between losses from derivatives and losses form regular capital assets; they are treated in accordance with the same principles. Consequently, although the rules on the taxation of derivatives may be considered difficult to 101s. 113
4.grasp, the outcome when applying them is logical. Thus to prevent legals. 114
5.uncertainty over the way to treat derivatives under the Swedish income taxs. 114
6.system, it is desirable to make the provisions more lucid.s. 114
7.Making the income tax provisions on derivatives more lucid is not the onlys. 114
8.challenge that derivatives impose on the Swedish income tax legislator. Thiss. 114
9.chapter illustrates how the present taxation of derivatives enables tax arbitrages. 114
10.opportunities. Generally, such tax arbitrages exist because the payoff froms. 114
11.derivatives is classified on the basis of the legal form of the derivative, resultings. 114
12.in capital gains or capital losses. Because capital gains, in principle, are taxeds. 114
13.more favorably than interest is, investments in derivatives are tax-preferred ifs. 114
14.the payoff from the investment is similar to payoff that is taxed as interest.s. 114
15.These tax-preferred investments, generally referred to as hybrid instruments ands. 114
16.synthetic instruments, are thoroughly examined in Chapters 5, 6, and 7.s. 114
17.102s. 114
Methods to Tax the Payoffs from
Hybrid Instruments
Derivatives and Composite Contracts
1.Chapter 4 made the important point that derivatives that are hybrid instruments give rise to tax arbitrage opportunities in the Swedish income tax system. These arbitrage opportunities commonly exist because the payoff from derivatives is taxed on the basis of realization, whether or not the payoff is expected income or expenses, or windfall gains or losses.s. 115
2.The tax arbitrage opportunities illustrated in relation to derivatives that are hybrid instruments also exist in relation to financial instruments that are not derivatives. These instruments are, in substance, combinations of different types of basic building block financial instruments with different risk exposures. As these combinations are contractually indivisible, they are generally considered to be legally distinct instruments for income tax purposes as well. These instruments – indivisible contracts that in substance are combinations of two or several building blocks – are referred to as “composite contracts” in this study.s. 115
3.The Swedish income tax treatment of composite contracts and the possible ways they challenge the Swedish income tax system are thoroughly examined in Chapter 6. To facilitate the analysis of that examination, this chapter presents and analyses various methods for dealing with the taxation of hybrid instruments. In Section 5.2, three methods for taxing the payoff from hybrid financial instruments are presented, and their relative efficiency in preventing tax arbitrage opportunities is established. Section 5.3 examines the appearance 103s. 115
4.of the three methods in the Swedish income tax system and Section 5.4 presentss. 116
5.the conclusions.s. 116
Taxing the Payoff from Hybrid Instruments
Contingent Debt Instruments
1.Section 4.4.3, Chapter 4 illustrates how derivatives can be structured in a ways. 116
2.that makes their payoff partly expected and partly unexpected. A stand-alones. 116
3.financial instrument, providing expected income as well as windfall gains ors. 116
4.losses, is usually referred to as a hybrid instrument.s. 116
5.Instead of structuring a derivative in a way that makes its payoff parts. 116
6.expected income and part windfall gains or losses, a hybrid instrument iss. 116
7.possible to attain by combining a financial instrument that typically payss. 116
8.expected income with a financial instrument that typically pays windfall gains ors. 116
9.losses. With reference to the basic building block financial instruments, fors. 116
10.example, a hybrid instrument is created by combining a credit-extensions. 116
11.instrument with a derivative, making the combination a distinct financials. 116
12.instrument: a composite contract. In case the long position in the composites. 116
13.contract guarantees the principle amount, the derivative building block iss. 116
14.typically an option: a price-insurance derivative. Where the party in a longs. 116
15.position of the composite contract risks the principle amount, the derivatives. 116
16.building block is typically a forward: a price-fixing derivative. Consequently,s. 116
17.the derivatives are used to transfer some or all of the risk of their underlying tos. 116
18.the composite contract.s. 116
19.A composite contract of this type is usually referred to as a contingent debts. 116
20.instrument, as it is, in form, a debt instrument; but its payoff is wholly or partlys. 116
21.dependent on variables that change due to unexpected events. Examples ofs. 116
22.contingent debt instruments are index-linked bonds – currency index-linkeds. 116
23.bonds or equity index-linked bonds, for example.s. 116
Two Types of Hybrid Instruments
1.Structured derivatives and contingent debt instruments represent two types ofs. 116
2.hybrid instruments. Their principle difference is that a derivative is a singles. 116
3.basic building block financial instrument, whereas a contingent debt instruments. 116
4.is a combination of building blocks.s. 116
5.In Section 2.6.2, Chapter 2 it is argued that the basic building block financials. 116
6.instruments are the core elements of any financial instrument. Thus from ans. 116
7.economic perspective, these building blocks cannot be split into other types ofs. 116
8.104 financial instruments, and the legal form of a basic building block financial instrument is that instrument’s principal “legal identity”. However, composite contracts like contingent debt instruments, which, in substance, are combinations of basic building blocks, can always be split into their stand-alone building blocks. Therefore, if a contingent debt instrument is considered to be a distinct legal instrument, it has, in principle, two legal identities. First, it is a combination of the basic building blocks of which it consists; therefore it is also a combination of their respective legal form. The second legal identity of a contingent debt instrument is the legal form given to that specific instrument.s. 116
9.On the basis of a no-arbitrage assumption, a financial instrument, with its two “legal identities”, provides tax arbitrage opportunities in case the legal identities are not treated equally for income tax purposes. More specifically, a contingent debt instrument gives rise to tax arbitrage opportunities if the payoff from the instrument is treated differently compared to the net payoff of its building blocks. Consequently, in addition to the tax arbitrage opportunities related to stand-alone derivatives that are hybrid instruments, contingent debt instrument may provide other such opportunities because it has two legal identities. As a result, contingent debt instruments present a greater challenge to the Swedish income tax system than do hybrid instruments in the form of derivatives.s. 117
Three Methods
1.Chapter 4 makes the point that hybrid instruments give rise to tax arbitrage opportunities because expected income or expenses are classified and taxed as interest in some situations; and in other situations are classified and taxed as capital gains or losses. In other words, tax arbitrage opportunities arise when the economic substance of the payoff from an instrument is not reflected in the legal form of that payoff. Although the economic substance of the payoff from a financial instrument is not reflected in the legal form of that payoff, however, tax arbitrage opportunities can be prevented if the legal classification is carried out in a methodical and consistent manner, based on the economic substance of the instrument generating the payoff.s. 117
2.As illustrated in Chapter 3, the Swedish income tax system taxes the payoff from financial instruments as interest and capital gains or losses. The classification of the two types of payoff is made without reference to the economic substance of the payoff. Furthermore, the classification is made independent of the economic substance of the instrument providing the payoff; rather, it is based on the legal form of the instrument generating the payoff.s. 117
3.As a method for preventing the tax arbitrage opportunities resulting from the legal classification and taxation of payoffs carried out in the Swedish income tax system, Section 4.4.5, Chapter 4 presents expected-return taxation – a method focusing on the economic substance of the payoff from a financial instrument. 105s. 117
4.More specifically, expected-return taxation involves the taxation of payoff baseds. 118
5.on the payoff being expected income or expenses versus windfall gains ors. 118
6.losses.s. 118
7.The third method presented to tax the payoff from hybrid instruments iss. 118
8.applicable solely on instruments such as contingent debt instruments, which ares. 118
9.composite contracts. The method entails taxation based on the legal form of thes. 118
10.payoff from an instrument. However, the classification of the payoff is made ons. 118
11.the basis of the economic substance of the instrument generating the payoff.s. 118
12.Thus composite contracts are reduced to its building blocks, and the payoffss. 118
13.from the respective building blocks are taxed separately, based on the legals. 118
14.classification of the payoff. In the tax literature, this method is routinely referreds. 118
15.to as bifurcation. More specifically:s. 118
16.…bifurcation is the recharacterization of a financial instrument that is, ins. 118
17.form, a single instrument as two or more fundamental financials. 118
18.instruments, and the sum of the taxes on the component instruments iss. 118
19.equal to the tax treatment of the single instrument.s. 118
20.The relative efficiency of the three methods, concerning their ability to precludes. 118
21.tax arbitrage opportunities, can be established on the basis of possible taxs. 118
22.arbitrage opportunities under each method. If the application of a method entailss. 118
23.that a hybrid instrument does not provide any tax arbitrage opportunities, thes. 118
24.method is considered efficient. Thus the method that prevents most tax arbitrages. 118
25.opportunities is considered to be the most efficient method. To ascertain thes. 118
26.relative efficiency of the three methods, the way in which they deal with as. 118
27.specific hybrid instrument can be determined. The specific hybrid instruments. 118
28.used for this purpose is a composite contract – specifically a contingent debts. 118
29.instrument.s. 118
The Efficiency of the Three Methods
The Payoffs from an Equity Index-Linked Bond and its Building Blocks
1.The contingent debt instrument, used to establish the relative efficiency of thes. 118
2.three methods to tax the payoffs from hybrid instrument, is a two-year equitys. 118
3.index-linked bond that guarantees its principle amount. Thus the basic buildings. 118
4.blocks of this equity index-linked bond are a two-year discounted bond: a zero-s. 118
5.coupon bond, and a two-year European call option on a specific equity index.s. 118
6.The following illustration presupposes that the two-year zero-coupon bond,s. 118
7.which is a building block of the equity index-linked bond, has a principal values. 118
8.106 of 100. Thus on the basis of an interest rate of 5 percent, its value at inception is 90.5. As a result, at the maturity of the zero-coupon bond, its payoff is 9.5 (100-90.5).s. 118
9.The two-year European equity index-linked call option, which constitutes the other building block of the equity index-linked bond, has an initial total value of 9.5. Consequently, if the equity index, to which the option is linked, develops in the negative over the duration of the option, the possible negative payoff from the option is a loss of 9.5. However, if the index develops positively over the duration of the option, the possible positive payoff is limitless.s. 119
10.The initial investment in the two building blocks of the equity index-linked bond is 100: 91.5 for the zero-coupon bond and 9.5 for the European call option. The no-arbitrage assumption entails that the initial investment in the equity index-linked bond is 100 as well. However, unlike its building blocks, which are considered to be two distinct financial instruments, the equity index-linked bond is considered to be a single instrument with a principal amount of 100. Therefore, the equity index-linked bond provides a positive payoff only if its value rises above 100. That, in turn, will happen only if the European call option has a value at maturity. If it has no value at maturity, the value of the equity index-linked bond equals 100 – the value of the zero-coupon bond. Consequently, the value of the equity index-linked bond never falls below its principal amount of 100, and therefore does not usually provide a negative payoff. However, the possible positive payoff from the equity index-linked bond is directly dependent upon the payoff from the option, being one of its building blocks. For that reason, any positive payoff from the equity index-linked bond is a result of an unexpected event, and therefore a windfall gain.s. 119
11.The following sections examine the income tax treatment of the equity index-linked bond and its building blocks on the basis of the three methods, in order to establish the relative efficiency of the methods.s. 119
Expected-Return Taxation
1.At an interest rate of 5 percent, the expected income of the equity index-linked bond is 10.5. With regard to the building blocks of the equity index-linked bond, 9.5 of the expected income is attributable to the zero-coupon bond and 1.0 is attributable to the call option. Thus if the value of the equity index-linked bond is 150 at maturity of the contract, 10.5 is taxed as expected income and 39.5 is taxed as windfall gain. If the value of the bond is 100 at maturity, 10.5 is taxed as expected income, and an equal amount is recognized as a windfall loss. 107s. 119
2.Consequently, the amount of expected income is the same whether thes. 120
3.taxation is carried out on the basis of the equity index-linked bond or on thes. 120
4.basis of its building blocks. Therefore, the expected-return taxation effectivelys. 120
5.prevents all tax arbitrage opportunities resulting from a difference in the taxations. 120
6.of a composite contract and its building blocks. Furthermore, Section 4.4.5,s. 120
7.Chapter 4 illustrates that expected-return taxation also prevents tax arbitrages. 120
8.opportunities related to stand-alone instruments, which are hybrid instruments.s. 120
Bifurcation
1.As illustrated in Section 5.2.4.1, the equity-index bond is, in substance, as. 120
2.combination of a zero-coupon bond and a European equity index-linked calls. 120
3.option. Thus applying bifurcation as a method of taxing the equity index-linkeds. 120
4.bond entails that the taxation is carried out on basis of the zero-coupon bond ands. 120
5.the call option. If the value of the bond is 150 at maturity, 9.5 would bes. 120
6.attributable to the zero-coupon bond and taxed as interest on an accrual basis.s. 120
7.The remaining payoff of 40.5 would be attributable to the call option and taxeds. 120
8.as a capital gain at maturity of the option. If the value of the bond is 100 ats. 120
9.maturity, 9.5 is taxed as interest and an equal amount is recognized as a capitals. 120
10.loss. However, as capital losses from equity index-linked options are nots. 120
11.possible to entirely offset against interest income, the tax treatment would entails. 120
12.the paying of taxes, although the net payoff from the equity index-linked bond iss. 120
13.zero.s. 120
14.There is a principle difference between expected-return taxation ands. 120
15.bifurcation: the latter method entails the taxation based on legal form, whereass. 120
16.the former is based on the economic substance of the payoff. Thus tax arbitrages. 120
17.opportunities resulting from the legal classification of the payoff from thes. 120
18.building blocks of a hybrid instrument cannot be addressed by bifurcation. Ins. 120
19.such cases, expected-return taxation appears to be the only suitable method.s. 120
Taxation on the Basis of the Legal Form of the Hybrid Instrument
1.The third method examined here is the taxation of hybrid instruments based ons. 120
2.their legal form. In the Swedish income tax system, this method is typicallys. 120
3.applied to the taxation of derivatives, which are hybrid instruments.s. 120