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Alvin C. Warren, Jr., Financial Contract Innovation and Income Tax Policy, 107 Harv. L. Rev. 460 (1993).

Abstract: The innovation in capital market contracts over the last twenty years has been remarkable. A limited set of familiar instruments (essentially stock, debt, convertible debt, and some options and futures) has been replaced by an array of hundreds of contracts, some of which are marketed to retail investors, whereas others are used primarily by financial managers. This innovation has had many sources, including fluctuations in currency and interest rates, avoidance of government regulation, inconsistencies in the income tax, and analytical advances in understanding and managing risk. Much of the innovation can be decomposed into three continuing developments: 1. Disaggregation: Traditional financial contracts, such as stocks and bonds, have been disaggregated into their constituent parts and separately marketed. For example, government debt securities have been "stripped" into principal and interest components. 2. Recombination: The disaggregated parts of traditional instruments have been recombined into new financial products. For example, interest payments on what is otherwise debt may depend on the value of a specified index of stock prices. 3. Risk Re-allocation: A group of innovative products, collectively known as notional principal contracts, has been developed to allow hedging or speculation with respect to commodity prices, interest rates, currency exchange rates, and other risks. Continuous disaggregation, recombination, and risk reallocation have produced a changing array of new financial contracts that pose a serious challenge for the income tax. 6 The purpose of this Commentary is to elucidate one of the underlying reasons for that challenge and to identify potential responses. In brief, the argument is that our realization-based income tax has relied on a dichotomy between fixed and contingent payments that has never been completely coherent. Recent innovations in financial contracts allow taxpayers to further exploit that incoherence. Part I of the Commentary develops this argument, while Part II illustrates the resulting analysis with three examples of new financial contracts. This two-part approach is followed because the basic conceptual analysis is independent of the contracts in existence at any given moment, but the challenge to the income tax is best understood by reference to actual transactions. Simple numerical examples are used to illustrate the points made in both Parts. Although this Commentary focuses on realization, which concerns the timing of taxation, financial innovation presents other significant difficulties for conventional tax distinctions. For example, many commentators have pointed out that the character (capital versus ordinary) and source (domestic versus foreign) of income and deductions are unsettled in many new products.8 Rather than addressing all such questions, the goal of this Commentary is to show why innovative financial contracts provide a serious challenge to an income tax based on realization, even in the simplest case of purely domestic transactions without special treatment for capital gains and losses.