Taxation aspects of financial derivative instruments

Abstract

Derivatives are the fastest-growing financial instruments of our time. They are drawn up on simple concepts and yet have revolutionized the way international business is carried on. The main derivatives are forwards, futures, swaps and options and they are used mostly for hedging financial risk. The simple concepts and versatility on which they are based are meant that these four basic instruments have been combined to produce new financial products. Despite the variety, derivatives involve four cash flow situations occurring on contract entry, maturity, early termination, or periodically. Each of these situations may attract specific profit-recognition or tax considerations. These are usually determined by such concepts as the characterization of the income and expenditure, the timing for the recognition of profits and losses and any similarities that derivatives have with other financial instruments. Because of the fast development of financial derivative instruments accounting and tax rules have lagged behind in this area. Full recognition in International Accounting Standards has only recently been made. Unfortunately, some of the concepts adopted are not compatible with traditional tax concepts and therefore International Accounting Standard 39 has done little to clarify the tax position of derivatives. A study of the general income tax principles shows that derivatives related income (of the non-trading type) cannot be specifically categorized. This may pose some difficulties in the case where countries adopt a particular tax regime in connection with derivatives. Malta's tax legislation is far from providing adequate rules in this regard. Indeed, the conclusion reached in this study is that despite the Malta Financial Services Centre's efforts to place Malta on the map of the financial world, we can never say that we provide comprehensive financial services unless and until proper financial derivatives legislation is in place.