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Using the income tax system as your hedge counterparty


A strain of the academic literature on taxation and risk taking emphasises the income effect and consequent transfer of risk to government through the income tax system in the presence of scaling of risky positions. The policy implications of this literature have been explored in considerable detail, although the practical significance for tax policymakers is ambiguous given the tax and non-tax constraints on scaling under the personal income tax. In contrast, fragmentary transactional evidence suggests that scaling of risky positions may have its most practical application in the context of corporate hedging transactions where many of the same tax and non-tax constraints do not apply. In fact, risk-transfer transactions in this very different context have been the subject of some recent attention by tax policymakers and tax administrators.

This paper explores the case for, and design of, a loss limitation intended to address the transfer of risk to government that otherwise is the result of hedged positions that are scaled to provide imperfectly offsetting pre-tax cash flows but perfectly (or near perfectly) offsetting after-tax cash flows. Although the case for such a limitation extends broadly to the entire range of such transactions, perceptions of costliness associated with the identification exercise, as well as perceptions of a negative impact on the decision to hedge, may lead to a more narrowly focused loss limitation patterned on legislation recently adopted by UK Inland Revenue. For the much more limited subset of risk-transfer transactions that are entered into for the purpose of providing a tax benefit, narrowly construed, general anti-tax avoidance rules and/or doctrines can provide an effective response. An example of this type of transaction is the asymmetric swap that is the subject of a taxation determination released by the Australian Taxation Office (ATO).

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Click here to expand/collapse more articles by Tim EDGAR.
Amir Aghdaei CTA
Amir is an LLM Candidate, University of Sydney. - Current at 01 July 2013


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