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)
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
4.To determine the legal form of a composite contract, it is necessary tos. 120
5.disregard its building blocks. Thus in contrast to bifurcation, taxation based ons. 120
6.the legal form of a hybrid instrument entails that a composite contract, like thes. 120
7.equity index-linked bond, is considered to be an indivisible contract for incomes. 120
8.tax purposes.s. 120
9.108s. 120
10.Taxing the payoff of the equity index-linked bond on the basis of its legal form gives an essentially different result compared to the previous methods. Considering the equity index-linked bond as an indivisible instrument, with a principle amount of 100, any payoff from the instrument is dependent on unexpected changes in the equity index. Thus the possible payoff of the instrument is too unpredictable to be taxed as interest, and the entire payoff from the instrument is taxed as capital gains.s. 121
11.If the equity index-linked bond provided expected payoff designated to be interest, and that payoff were possible to establish on the basis of the principal amount of the instrument, the payoff would be taxed as interest. For example, if the building block of the equity index-linked bond – a zero-coupon bond – were to be exchanged for a discounted coupon bond, the taxation of such equity index-linked (coupon) bond would be similar to the taxation carried out on the basis of the previous methods. Thus if the coupon bond paid 4.75 at the end of each year, the taxation of the equity index-linked (coupon) bond would be as follows. In Year 1, 4.75 would be taxed as interest. Presupposing the value of the equity index-linked (coupon) bond to be 145.25 at maturity, the taxation in Year 2 would involve the taxation of 4.75 as interest and 40.5 as a capital gain. If the value of the bond is 95.25 at maturity, 4.75 is taxed as interest, and 9.5 is recognized as a capital loss.s. 121
Preventing Tax Arbitrages
1.From the examination of the three methods of taxing hybrid instruments, it follows that only expected-return taxation fully prevents possible tax arbitrages related to hybrid instruments. However, as is noted in Section 4.4.5, Chapter 4, the application of this method requires such major changes in the Swedish income tax system that it must be considered unrealistic.s. 121
2.Bifurcation is the second-best method for preventing tax arbitrage. This method has the disadvantage of not being able to be used to prevent the tax arbitrage opportunities arising in relation to stand-alone instruments, which are hybrid instruments. However, in relation to composite contracts, it fully prevents tax arbitrage opportunities that would arise as a result of the composite contract being taxed differently compared to its building blocks. Finally, the least efficient method for preventing tax arbitrages related to hybrid instruments is taxation on the basis of the legal form of the instrument. This method requires the composite contract to be considered indivisible for income tax purposes. Thus income must be classified in relation to the composite contract, entailing that what is considered interest in relation to one of its building blocks is not necessarily considered interest in relation to the composite contract. Rather, this 109s. 121
3.method stimulates the creation of hybrid composite contracts in order to exploits. 122
4.tax arbitrages.s. 122