An Analysis of Whether Tax Systems Can Accommodate Financial Product Innovation — The Tax Issues Raised by Derivatives

Abstract

Financial product innovation has increased consistently over the past 40 years because of the 1980s financial deregulation. Since the appearance of “innovative financial instruments” (IFIs), tax systems across the globe have struggled to regulate them because IFIs present complex issues concerning their own financing characteristics, timing, and income recognition. This paper examines the difficulties that tax systems have in accommodating pure derivatives, hybrids with at least one derivative component, and synthetic derivatives. Part I introduces the derivatives galaxy. Part II considers the main tax issues that derivatives (the three above-mentioned categories) create for tax systems. Part III expands on six points that for various reasons limit tax systems’ ability to smoothly accommodate derivatives.

Keywords: law, tax, taxation, financial product innovation, IFI, derivatives, TAAR, GAAR

JEL Classification: K34