New York State Bar Association Tax Section Report on Credit Default Swaps September 9, 2005 September 9, 2005 New York State Bar Association Tax Section Report on Credit Default Swaps I. Introduction............................................................................................................................1 A. Overview ............................................................................................................................. 1 B. Recommendations .............................................................................................................. 2 II. Description of Types of CDS.................................................................................................4 A. Growth of the CDS Market................................................................................................ 4 B. Single-Name CDS .............................................................................................................. 5 1. Description.................................................................................................................... 5 2. The Notice’s Questions on CDS Contractual Terms .................................................... 6 3. Common Purposes for Entering into CDS.................................................................... 7 (a) Management of individual capital lines............................................................ 7 (b) Regulatory capital management........................................................................ 9 (c) Economic capital management ......................................................................... 9 (d) Trading/arbitrage transactions.......................................................................... 9 (e) Portfolio management/alternative investments............................................... 10 (f) Market-making................................................................................................ 11 C. Collateralized Debt Obligations....................................................................................... 12 D. Single-Tranche CDS; nth to Default CDS; CDO-Squared CDS .................................. 13 E. Index CDS ........................................................................................................................ 15 F. Other CDS-Related Products........................................................................................... 16 G. The Notice’s Questions on CDS Pricing......................................................................... 17 1. Pricing......................................................................................................................... 17 2. Price Dissemination .................................................................................................... 18 III. Description of Other Credit-Protection Instruments .......................................................18 A. Letters of Credit................................................................................................................ 18 B. Guarantees ....................................................................................................................... 19 C. Financial Guarantee Insurance...................................................................................... 20 1. In General.................................................................................................................... 20 2. Comparision to CDS................................................................................................... 22 IV. Participants in the CDS Market .........................................................................................25 A. Banks ................................................................................................................................ 26 1. Bank Usage of CDS.................................................................................................... 26 2. Regulation................................................................................................................... 27 B. Insurance Companies ...................................................................................................... 28 1. Insurance Company Participation in the CDS Market................................................ 28 2. Transformers............................................................................................................... 29 3. RSATs......................................................................................................................... 30 4. Negative Basis Trades................................................................................................. 30 5. Regulation................................................................................................................... 31 C. Securities Dealers............................................................................................................. 31 D. Hedge Funds .................................................................................................................... 32 i V. U.S. Federal Income Tax Issues..........................................................................................32 A. Consequences of Different Tax Characterizations of CDS............................................ 33 1. Rules Applicable to Foreign or Cross-Border Transactions....................................... 34 (a) Excise tax and regular withholding tax........................................................... 34 (b) U.S. trade or business...................................................................................... 34 (c) PFIC rules ....................................................................................................... 35 (d) Subpart F rules ................................................................................................ 35 2. Rules Applicable to All Transactions ......................................................................... 36 (a) Timing............................................................................................................. 36 (b) Character......................................................................................................... 37 (c) Other rules....................................................................................................... 38 B. Insurance or Derivative Financial Instrument? ............................................................ 39 1. Policy Considerations................................................................................................. 39 (a) Appropriate application of the rules applicable to insurance policies and insurance companies ....................................................................................... 39 (b) Legal entity taxation....................................................................................... 40 (c) U.S. trade or business issues........................................................................... 41 (d) Sourcing rules; withholding tax; excise tax.................................................... 44 (e) Timing and character...................................................................................... 46 (f) Guarantees....................................................................................................... 47 2. Definition of Insurance ............................................................................................... 47 3. Application to Conventional CDS .............................................................................. 48 (a) Insurance in its commonly accepted sense (first requirement)....................... 49 (b) Insurance risk (second requirement)............................................................... 49 (c) Shifting of risk (third requirement)................................................................. 49 (d) Risk distribution (fourth requirement)............................................................ 49 (e) Insurable interest............................................................................................. 50 4. Recommendations....................................................................................................... 51 C. Notional Principal Contract or Option? ......................................................................... 54 1. Timing Rules............................................................................................................... 55 (a) Possible models for CDS timing rules............................................................ 55 (b) Definition of notional principal contract......................................................... 58 (c) Anti-abuse rules.............................................................................................. 58 (d) Proposed regulations on swaps with contingent nonperiodic payments......... 60 2. Character Rules........................................................................................................... 61 Bibliography ..................................................................................................................................63 A. Regulatory Materials......................................................................................................... 63 B. Rating Agency Materials .................................................................................................. 65 C. Industry Association Materials ........................................................................................