Taxation of Credit Derivatives
31 Pages Posted: 22 Nov 2009
Date Written: November 19, 2009
One arguably good thing about the current financial crisis is that it has broadened public understanding of the global financial system. Few people had heard of credit default swaps two years ago, but these instruments have, since then, forced themselves on the attention the most casual reader of financial news. Credit default swaps brought insurance giant AIG to its knees, and precipitated a $100 billion U.S. government bailout of the company. More recently, it has been reported that hedge fund manager John Paulson made more than $3 billion during 2008 using credit default swaps to bet against subprime mortgages.
A credit default swap is a bilateral contract between a “credit protection buyer” and a “credit protection seller.” Under a typical contract, the buyer pays a quarterly fee to the seller throughout the contract term, and the seller agrees to make a payment to the buyer in the event of a default by a third person (reference entity) on debt that it has issued (reference obligation). For example, B and S might make a swap with reference to bonds issued by IBM Corp., under which B must make quarterly payments to S for five years, and S must, in the event of IBM’s default on the bonds during that five-year period, pay to B an amount equal to the excess of $10 million over the post-default value of $10 million of IBM bonds.
This paper is about the U.S. taxation of credit default swaps. The tax treatment of these contracts under current law is unclear. The paper explores several possible approaches, including analyzing these swaps as contingent put options, applying the regulations on notional principal contracts to them, treating credit default swaps as insurance, and extending the mark-to-market rules to cover credit default swaps. Because the tax treatment of these transactions should reflect their financial and economic substance, the paper begins with an extended description of credit default swaps and the ways in which swaps are used in financial and investment transactions.
Keywords: taxation, derivatives
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