PLAYING DICE: Why Does the Taxation of Financial Derivative Instruments Worry Us? (Part One)

Introduction

“My sincere apologies for the predicament I have left you in.” These apologies belong to the fax sent by Nicholas Williams Leeson, responsible for the collapse of Barings Bank in 1995 after losing a billion dollars in derivatives.

In Peru, until 2008, our Income Tax Law (LIR) said little about Financial Derivative Instruments (FDI). Currently, we have detailed regulation covering everything from their classification as Peruvian-Source Income (RFP) to their deductibility and their classification as hedging or non-hedging.

I. Content in the Income Tax Law (LIR)

1.1 Scope of Application

Since 2007, FDIs have been regulated…

CCS Case: Cross Currency Interest Rate Swap contracts cover both currency and interest rates. The law does not clearly specify how to proceed with withholding in these hybrid cases.
Hedging Benefit: The greatest benefit is being able to deduct the loss. If an exempt Non-Profit Organization (ASFL) does not qualify its FDI as hedging, any gain obtained could be taxed.

II. Anti-Avoidance Rules and Controversies

1.3 A Specific Anti-Avoidance Rule

Article 44(q) prohibits the deduction of losses if:

The FDI was entered into with entities in Tax Havens.
The taxpayer maintains symmetrical positions (e.g., contracting a call and a put for the same risk to defer income and accelerate losses).

1.4 The Causality Principle

There is a current trend that requires compliance with the Causality Principle to offset losses in speculative FDIs. We disagree with this, as Article 50 allows for the offsetting of losses against future gains from other speculative FDIs without requiring strict causality, which is only necessary to qualify an FDI as hedging.

III. Extra-Tax Purpose of FDIs

The objective of taxing short-term currency derivatives (currently less than 3 days, previously 60) is to reduce excessive volatility in the Peruvian exchange market, discouraging very short-term speculation that affects the stability of the national currency.

Originally published by Thomson Reuters Global Resources on 11/30/2020.