Some types of credit derivatives on asset-backed securities could be ruled to be guarantees or insurance contracts, which would make them subject to a harsher tax regime and, in the case of insurance, prevent banks from trading them.
The International Swaps and Derivatives Association is drafting documentation for synthetic asset-backed securities trades and under one of the settlement methods--known as pay as you go--sellers of protection would be liable to make up shortfalls in the ABS payments when they were originally scheduled. Donald Carden, partner at Clifford Chance in New York, said, "Pay as you go will bring [credit derivatives on ABS] closer to a guarantee and may make it subject to withholding tax."
The IRS has issued a note in July saying they were examining how credit derivatives should be taxed. Carden said, "The IRS is struggling with the best way to characterize CDS and to the extent you move away from cash settlement the contract starts to more closely resemble a guarantee or insurance and less resemble an option or a swap. The question is whether moving to pay as you go would tip the scales."
A similar problem concerning withholding tax already exists in the Eurobond market. A coupon payment under a Eurobond may generally be made without withholding for U.K. tax under the quoted Eurobond exemption, however a payment under a guarantee of that Eurobond may not benefit from the same exemption, explained Patrick Clancy, counsel at Shearman & Sterling in London. ABS securities are often quoted Eurobonds for withholding tax purposes, while the credit derivative will not be. But a pay as you go default swap should be written so it doesn't amount to a guarantee and so should not be seen as a payment of or in respect of the missing coupon. It should merely pay an amount equal to the coupon to the protection buyer who, after all, doesn't need to own or to continue to own the ABS securities.
London-based lawyers said there is also a risk the contract could be interpreted as an insurance contract at least partly because you would need to own the ABS in order to know when the coupons were scheduled and whether they had been paid. The requirement to own the security, and therefore suffer loss, is one the main differentiating factors between derivatives and insurance contracts. Simon Firth, partner at Linklaters in London, said, "It is potentially an issue, but it is surmountable."
Louise Marshall, spokeswoman at ISDA in New York, said the trade association has not discussed this issue but if members raise concerns the tax committee may look into it. The documents are expected to be finalized before the summer.