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German Ministry of Finance opposes separate reporting...

German Ministry of Finance - separate reporting...

... of structured financial instruments

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Structured financial instruments

Structured financial instruments are assets which, from a financial perspective, consist of an underlying instrument (generally a basic debt instrument such as a loan) and one or more embedded derivatives (options, futures, swaps or similar). Structured financial instruments are documented in a single contract, and in the event of securitisation, also as a single security. The terms of agreement for structured financial instruments specify the yield and repayment profile for the instrument without referring to the individual financial components contained. Examples of structured financial instruments include, for example, convertible bonds or debt instruments, credit linked or credit default notes as well as certificates, for which the payment profile is dependent on the trend in prices of certain reference items (indices, shares, commodity prices and similar). 

Recognition as a single asset or separately?

For the issuers and bearers of structured financial instruments, the question arises when preparing the financial statements and tax accounts as to whether these instruments should be recognised and subsequently measured as a single asset or their financial components (underlying instrument and derivatives) be recognised and measured separately. To date, accounting practice has been oriented towards the recognition criteria of the German Institute of Public Auditors (IDW, IDW RS HFA 22). Accordingly, structured financial instruments are generally recognised as a single asset in the financial statements, if the embedded derivatives do not create a significantly increased or different risk profile compared to the underlying instrument. Such additional risks could consist for example of market risk that exceeds interest rate risk, exposure beyond the credit risk of the issuer, the risk of negative interest rates or the potential doubling in initial yield on the underlying instrument.

With regard to the presentation of structured financial instruments in the tax accounts, it is disputed whether IDW requirements concerning the authoritative principle have an impact on tax accounting or whether tax legislation does not apply to legally single assets that are split solely on the basis of financial interrelationships. To date, there has been a lack of clear guidelines from tax authorities or tax courts, meaning that the commercial law approach has often been adopted in corporate practice. 

German Federal Ministry of Finance favours treatment as a single asset

On request of the Ministry of Finance for North Rhine-Westphalia, the German Federal Ministry of Finance (BMF) has now stated its position on the issue of reporting structured financial instruments in the form of credit-linked notes (CLN). In its written reply, the BMF rejected the separate reporting of debt securities and embedded credit default swaps (CDS). In justification of its decision, the Ministry commented that assets which have to be reported separately must only be those which are valued separately and are able to be sold separately. In any case, embedded CDSs cannot be sold separately because CLNs are debt securities issued with a single International Securities Identification Number and it is not generally possible to strip individual components. According to generally accepted opinion, the embedded CDS cannot be regarded a commercially separate instrument.

The BMF added that the IDW Auditing and Accounting Board Statement RS HFA 22 does not represent generally accepted accounting principles applicable to tax accounts. In its opinion, the Auditing and Accounting Board Statement only interprets the accounting principles under German commercial law and does not therefore display an obligation for tax accounting. This opinion has attracted attention because this ultimately means that the IDW standpoint can, at most, provide guidance on interpretation with regard to other structured financial instruments and that this should ultimately also apply to the financial statements. This is because tax legislation generally does not provide for a difference in treatment of structured financial instruments in the tax accounts compared to the presentation in financial statements under commercial law.

Tax consequences

Whether structured financial instruments are treated as single assets or separately for tax purposes and, as a result, are regarded as one or multiple assets has a wide-ranging impact on the taxation of earnings from these assets. In the event of a negative trend in market value, standalone derivatives are subject to the tax prohibition on provisions for onerous contracts. However, this does not apply to a structured financial instrument as a single asset. A restriction on offsetting losses on forward transactions applies for tax purposes. These may only be offset against gains from other forward transactions. A forward transaction embedded in an underlying instrument does not usually satisfy the requirements of the tax definition of forward transactions in cases where the instrument is treated as a single asset for tax purposes. Ultimately, it will have to be examined in the individual case to what extent gains or losses to be treated as derivative income in the case of separate recognition could, within the scope of treatment as a single asset, lead to an interest expense or income in the sense of an interest rate cap or an obligation to add debt fees for trade tax purposes.

Source: KPMG Corporate Treasury News, Edition 84, September 2018
Author: Dr. Dirk Niedling, Partner, International Tax, dniedling@kpmg.com

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