II. Traditional Credit Risk Management Tools
Prior to the development of credit derivatives, lenders hedged credit risk by obtaining letters of credit, requiring guarantees, or purchasing insurance. With credit derivatives, a lender is able to achieve the same credit risk management objectives as obtained from the traditional methods, but with greater accuracy and at a lower cost, while at the same time preserving client relations.
Letters of credit, guarantees, and insurance all place the lender in the same financial position as if a default has not occurred. For instance, a standard letter of credit is an instrument issued by a bank guaranteeing the payment of a customer’s draft for a specified period up to a stated amount. The letter of credit effectively substitutes the buyer’s credit with the bank’s, greatly reducing the seller’s risk. In the event that the buyer does not make good with its commitment, the bank will see that the seller is put in the position that it would have been had the buyer not defaulted. A credit default swap also ensures that a lender is made whole by transferring the credit risk to another party. In credit default swaps, one party receives periodic payments or an up-front fee in exchange for agreeing to make a payment to another party if a particular, predetermined credit event occurs. The swap allows the lender to eliminate its exposure to the debtor’s credit risk while keeping the loan on its balance sheet and maintaining client relations.
III. Taxation of Total Return Swaps
A total return swap is a contract where one party (hereinafter: the receiver) receives the total positive return on a security or basket of securities (hereinafter: the reference obligation) from another party (hereinafter: the payer). In exchange, the payer receives periodic fixed or floating-rate payments on the reference obligation plus any depreciation in capital value. (See Diagram 1, below.) The Most relevant guidance with respect to the taxation of total return swaps is contained within the rules governing notional principal contracts.
IV. Notional Principal Contracts
A notional principal contract is defined as a financial instrument that provides for payments by one party to another at specified intervals, calculated by reference to a specified index upon a notional principal amount, in exchange for a promise to pay similar amounts or other specified consideration. A “specified index” can be any of the following:
- fixed-rate, price, or amount (or a combination thereof)
- index based on objective financial information; or
- interest rate index regularly used in normal lending transactions between a party to the contract and unrelated persons.
A notional principal amount is a specified amount of money or property that, when multiplied by the specified index, measures a party’s rights and obligations under the contract, but is not loaned or borrowed between the parties. Most total return swaps will be considered notional principal contracts for tax purposes. In a simple total return swap arrangement (such as the one described above), the payer’s periodic payment of coupon plus the net change in the capital value of the reference obligation (i.e national principal amount) and there receiver’s periodic fixed or floating rate payments are all considered payments at “specified intervals” and calculated by reference to a “specified index” (i.e. LIBOR and coupon payment) (See Diagram 2, below). If the total return swap only calls for bullet payments by each party at maturity, the swaps are not a notional principal contract as there are no payments being made at specified intervals