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Derivative financial instruments have become essential tools of modern business and investment. Through their ability to separate, replicate, and recombine economic attributes into new forms of derivatives, financial instruments enable the shifting and redistribution of risks. Indeed, the growing sophistication of these transactions has been driven by the demands from business and financial markets for more effective risk management. These developments, however, raise serious challenges to income tax systems, involving issues of the character and source of income, the timing of income and deductions, treaty classification of payment streams, and identification of the owner of financial instruments.
Moreover, the greater flexibility afforded to taxpayers by such transactions has expanded opportunities for tax arbitrage. Tax systems that have responded to these concerns have adopted a variety of different approaches. Each of these methods has merit in certain circumstances, but none provides a comprehensive solution to the tax issues presented. Thus governments and tax authorities should consider seriously all of the above, either individually or in combination, in developing new rules in this area; suitable approaches must balance the various tax policy objectives at stake, while addressing the risk management needs of taxpayers.
Ultimately, the innovation and expanded use of financial instruments test the viability of the current frameworks of income tax systems and international tax agreements, and will continue to demand effective and appropriate responses.
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