3.1.2 Debt versus equity
Treatment of company issuances on the debt-equity spectrum receives different treatment for tax, GAAP, and rating agency purposes. Tax takes a binary view, such that an instrument is either debt or equity with highly significant ramification with regard to e.g interest deduction, dividends received deduction, interest netting, earnings stripping, and withholding. GAAP and the rating agencies recognize that debt and equity can be viewed as two extremes of instruments on a spectrum. Bankers and lawyers devote significant effort to arbitraging the tax, GAAP, and rating agency rules, particularly aiming to obtain a tax deduction with some equity “credit” from the rating agencies. Such hybrid instruments require higher than normal internal scrutiny and almost invariably a tax opinion.
GAAP and tax treat derivatives very differently. Contracts such as futures, forwards, options, caps, floors, swaps, and swaptions are often required to be marked to market under GAAP rules (SFAS 133). Tax treatment generally follows the form, unless there is reason to think that the form may mask as inappropriate tax benefits. There are different rules for forwards, futures, options, and swaps. Contracts with characteristics of more than one of these prototypes (called hybrids) are generally treated for tax purposes like the contract which the hybrid most closely resembles. Bifurcation (dividing the contract up into the component parts) is very rare in tax law because there are no “lowest common denominators” in finance – any derivative contract can be carved up economically into any number of a different combinations of other contracts. No one combination can be categorically regarded as more correct than any other. Hence, tax law resists dividing up contracts, unless to do so is necessary to prevent abuse.
3.2 Strategies for managing tax consequences of finance activity
3.2.1 Get to know the treasurer
It is vital for a company’s tax director to have alliances throughout the corporate organization, no less so than with the treasurer. The hedging rules require same-day identification of hedging transactions — those transactions that manage certain financial risks, such as floating interest rates or fluctuating oil prices. In order to make same-day identifications, the tax department needs to secure cooperation from the company’s treasury department to ensure that the tax department is informed when a hedging transaction is entered into. The tax department also needs to understand what risk is being hedged and over what time period. Communication can be systematized using computerized notations when hedges are entered into, or some other mechanism can be used to reduce the compliance burden. When hedges are not identified or are misidentified, the IRS can whipsaw the taxpayer – particularly by characterizing losses on the hedge as capital.
Derivatives that are not hedges are also important to be aware of. Many derivatives form parts of a straddle and require loss deferral. Changes in market conditions could result in significant capital losses, and so the tax department must be kept informed of the timing of sales or termination of these contracts.
3.2.2 Develop procedures and follow them
Any interaction with the IRS is eased with the presentation of clear, easy to understand procedures for the treatment of a particular financial activity or transaction. Some examples include a file containing documentation of all hedge transactions attached to the contract creating the risk being hedged, or a schedule containing the algorithm for the accrual of swap transactions. Even if there are errors in implementation, for example on transaction of many failed to be identified as a hedge, the IRS is usually more lenient if there is a proper method that was bypassed in error. Under the hedge regulations, there is an exception for “inadvertent failure”, but this exception does not extend to the failure by the tax department to know that there is a hedging programme being undertaken in the company.