Morrison & Foerster: Structured products taxation in three easy steps

By Emma Trincal

New York, Jan. 25 - Taxation of structured notes can be daunting for investors. Levels and types of taxation may vary depending on many factors such as the percentage of protection and the timing of income payment. Morrison & Foerster gave a "Structured Notes Boot Camp" in its New York offices last week, underlining some of the basic ground rules. Shamir Merali, partner in the firm's tax practice group, gave the educational presentation.

In theory, a structured note is a package of cash flow between the issuer and investors, Merali said. Cash flows are contingent and provide investors with exposure to one or more securities or indexes. Some of the notes' features, such as caps, floors, leverage and partial principal protection, will have an impact on the taxation of the notes.

Investors are concerned about two important points when assessing their taxes, Merali said. One is timing, as investors prefer to defer recognition of income as long as possible. The second is the tax treatment itself and whether the returns will be treated as capital gains or as ordinary income.

In his presentation, Merali divided structured notes into three conceptual categories. Each category has its own set of tax rules.

Two tests

In order to define the correct category, investors need to first answer two questions.

The first question is whether the notes are principal-protected or not. If the notes are principal-protected, they belong to the Type 1 category, said Merali.

If the notes are not principal-protected, another test needs to be applied: Do the notes have a periodic coupon or not? Notes that are not principal-protected and that do not carry a periodic coupon fit into the Type 2 category.

Notes that have no principal protection but offer a periodic coupon belong to the Type 3 category.

Once those three categories are established, different types of taxation apply, said Merali. But only the first and second categories are easy to interpret, he noted.

Type 1: CPDI

The tax characterization of Type 1 notes is to be treated as debt for tax purposes, a direct consequence of their principal-protection feature.

Type 1 notes will be treated as contingent payment debt instruments (a "CPDI") and gains will be treated as ordinary income. The note will be subject to the original issue discount, also known as "phantom income." Such tax treatment, which is not the most favorable, requires investors to determine a "comparable yield" or a yield for a fixed-income instrument with a comparable structure. Investors may then accrue income at this comparable yield. They will also be required to adjust the difference between actual payment and projected payments.

Type 2: Capital gain

Type 2 notes, or zero-coupon notes with no principal protection, are more straightforward, according to Merali's presentation.

They are often associated with some of the most popular structures such as enhanced capped notes linked to an index. With those products, there is no current inclusion of income and returns are treated as capital gains or losses upon sale or at maturity.

Type 3: Unclear

The third type of products - Type 3, which are interest-bearing notes with no principal protection - are the most difficult to characterize from a tax standpoint, said Merali. For such products, the law is "unclear," he noted.

In some cases, the notes may be treated as income-bearing instruments. Investors as a result have to accrue on a regular basis the entire coupon for ordinary income. In other cases, the capital gains treatment is more appropriate. Finally, in some situations, especially when principal protection is only partial, the tax treatment is unclear.

Bifurcation

Tax lawyers in those hybrid cases implement a technique called "bifurcation," which consists of treating the notes as if they were two embedded derivatives bundled together whose tax treatment is clearly established by tax law instead of one complex financial security whose tax treatment remains unclear, said Merali.

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