A. The State

22. It is good practice to provide an explicit legislative authorization for the State to issue bonds and bills.²² Such authorization is particularly advisable from the perspective of those legal systems that strictly follow the principle that the State and its agencies are allowed to do only what is directly permitted under their governing law. However, even for those legal systems that authorize bond issuance by the State under general principles of constitutional law, providing an explicit statutory authorization brings legal certainty and clarity. Such authorizing legislation can be the country’s “public debt law”²³—that is, the law codifying a comprehensive regime for public debt—or another, more specific legislative instrument, such as a law of public debt securities.²⁴ The authorizing legislation will often combine the authorization to issue bonds with some procedural aspects, such as which political authority approves, on behalf of the State, the issuance. The authorizing legislation may also include rules on the form and other aspects of the bonds.

23. A consequence of an explicit authorization should be that all bonds and other debt securities issued in accordance with the authorizing legislation are valid obligations of the State. This entails, in particular, that debt limit rules have no impact on the legal validity of the bonds. There are countries where that is not the case.²⁵

24. The public debt law should also include the longer-term objectives relating to debt management; the requirement to have a debt management strategy to achieve those objectives; and requirement to have an annual evaluation submitted to the Parliament/Congress. The objectives set out in that law sometimes include one to support the development of the domestic debt market. These objectives can be drafted using different legal language, but typically the relevant legislation has words to the following effect:

The objectives of State debt management are to ensure that: (i) the financing needs of the State always are met on a timely basis; (ii) its borrowing costs are as low as possible over the medium to long run, consistent with a prudent degree of risk; and (iii) development of the domestic financial market is promoted [emphasis added].

25. To achieve the objective of promoting a well-functioning domestic financial market, the debt management strategy would then include the actions of undertaking “planned borrowings and other debt management activities” for the express purpose of promoting the development of that market. Further, the relevant overarching strategy document normally includes: a plan to build up a yield curve in the domestic market by a regular supply of government securities (bills and bonds); progressive extension of the maturities; and consolidation of debt issues into a few liquid market benchmarks. In this regard, the scope of the LCBM also typically covers the money market (traditionally consisting of bills of up to one year), which are also very important in both developing economies and emerging markets. Sometimes countries issue treasury bills with maturities longer than one year, which will then overlap with the usual suite of LCBs. A strategic and consistent approach to developing a government securities market along various maturities/tenors with a transparent/market-based yield curve becomes very important. Here a trade-off has to be made between increasing the roll-over risk in building up liquid benchmark loans, and a better-functioning domestic debt market that will reduce the cost in the medium to long run. For the purpose of supporting the development of the domestic financial markets, countries also sometimes issue debt securities even if they run a fiscal surplus, just to ensure there are sufficient securities available for secondary market transactions, particularly for the banking sector (as discussed above).

26. Practically speaking, the issuance of government bonds and other debt securities should also be thoughtfully sequenced. For instance, it is often worthwhile first building a trusted public debt primary and secondary market through the successful issuance of more vanilla securities to gain investor confidence and then subsequently seeking to build off that success by expanding the market to other debt securities. Achieving a trusted public debt primary and secondary market that builds and maintains investor confidence also requires transparency with respect to public debt management such as periodic overviews of domestic fiscal data and overall public debt levels (at all relevant levels of government) which requires appropriate reporting and monitoring mechanisms, all of which typically requires the coordinated involvement of MoF/Treasury and the central bank.

B. Other Public Bodies

27. For other public bodies, it is similarly good practice to include an explicit authorization to issue bonds and bills in the foundational legislation of those bodies. Most public bodies are only authorized to do what the law explicitly or implicitly allows them to do. For sub-national governments, an authorization to issue bonds and bills could be included in the general law establishing and organizing those bodies, such as a Law on Municipalities. For State-owned enterprises (SOE), this authorization could be included in the organic law of the SOE in question, or in legislation governing SOEs (or a sub-category of SOEs) generally.

C. Corporate Issuers

28. Corporate issuers should have an explicit legal authorization to issue bonds and dematerialized commercial paper. (Historically, no such authorization was required for paper negotiable instruments, such as promissory notes.) Many legal systems limit the authorization to issue bonds and other debt securities to certain types of companies, mainly the ones akin to the French société anonyme. This is because the legislator considers other types of companies, such as cooperatives and companies for small businesses, to be too small, or have the wrong (ownership) structure, to seek funding from the capital markets.

29. There are a few options to provide this authorization. One option is to provide a blanket authorization in the company law or the civil code. Another option is to generally authorize the issuance in the company law, subject to an express authorization in the by-laws or articles of association of the company, as adopted by the shareholders, or through specific resolutions of the managing bodies (e.g. board of directors).

A. The Substance: Contractual Framework of Local Currency Bonds

30. In many countries, local currency government bonds are not subject to a specific and well-calibrated contractual framework. Government bonds issued in foreign currency and governed by foreign (typically, English or New York) law will be subject to an elaborate set of contractual stipulations. For emerging markets and developing economies, this is often not the case for locally issued government bonds. This is not good practice, for a number of reasons. In relation to foreign investors, the absence of clarity and legal certainty on the contractual rights of bondholders will be an obstacle to attracting them. In relation to domestic investors, the lack of clear and appropriate contractual stipulations governing the most important asset of the financial system (in some cases together with central bank bills) will undermine the objective of developing financial markets and promoting good practices.

31. The solution to this often-overlooked problem lies in the careful design of an appropriate contractual framework for local currency government bonds and bills. There is no single best way of doing this. That being said, what is essential is a set of contractual General Terms and Conditions (T&Cs) for the bonds and bills.²⁶ In some countries, it will be useful to complement those with Specific T&Cs for a specific bond or bill (typically identified by its ISIN code). Some sovereigns find it also useful to issue an Information Memorandum (IM) for their bonds. However, the boundary between information and legal provisions is sometimes not as clear as it could be in those documents—IM are more useful for disclosure than for contractual purposes.

32. The legal design of such a contractual framework gives rise to a number of challenging and often fundamental legal questions.²⁷ In countries of the Civil Law tradition, an important question will be how the General T&Cs interact with Civil Code provisions on loan agreements. A second complex question concerns the interaction between contract and administrative law: some legal systems even have some form of “administrative contract law.” In common law countries too, the design of T&Cs may need to give due consideration to the common and statutory law rules governing loans of moneys.

33. The General T&Cs need not be elaborate, but they need to include a number of core provisions (see Box 2). The most important provision is the one on choice of law: a contractual clause should unequivocally establish that the bonds and bills are governed by the law of the issuing State. The second most important provision is the one on dispute settlement: the T&Cs should establish that the local courts have exclusive competence, thereby excluding a role for foreign courts and arbitration tribunals.

34. In contrast, there are other types of provisions that, while common in foreign law-governed bonds, are less expected in local law-governed government debt securities. Specifically, those T&C may include additional provisions on the status of the bonds and bills, events of default and negative pledge clauses.²⁸ While common in government bonds documentation under foreign law, these clauses are rather rare for local law-governed bonds. The same is valid for “collective action clauses,” as discussed in Box 3.

35. Tax certainty of treatment is also critical for holders of LCBs comprising government debt securities, especially foreign investors. Often the T&Cs (or accompanying IMs) are silent with respect to tax considerations. This is somewhat understandable because there are usually relevant tax concessions/exemptions in place (e.g. foreign investors are not taxed on gains, and interest withholding tax exemptions exist for coupon payments made to foreign holders, given both positions reflect international practice and represent the approach preferred by international FMIs). As discussed more comprehensively in section VIII below, the tax law settings applicable to LCBs need to be carefully integrated with the legal modalities relating to the issuance and trading of LCBs and the requirements of critical FMIs. While the ultimate tax treatment of a country’s LCBs is a matter of domestic tax policy, having regard to their capital markets development plan, relief for foreign investors on LCBs comprising government debt securities (and sometimes, in appropriate circumstances, other publicly issued securities) is common international practice for a number of reasons, including: lack of enforceability where securities are held through chains of offshore custody structures; the coupon could be calculated to recoup the withholding tax levied at source or otherwise become subject to a contractual gross-up for withholding tax (which means the withholding tax is still borne by the issuer by increasing the government’s borrowing costs, rather than the investor)²⁹; and trading/capital gains could otherwise be structured to achieve treaty protection by holding the investment through a tax treaty country (given that tax treaties typically give the primary right to tax gains to the country of the investor’s residence). For present purposes, a baseline tax treatment for nonresident investors reflecting common international practice with respect to the treatment of LCBs comprising government debt securities is set out in (Table 1) below. However, as noted above, the ultimate tax treatment of a country’s LCBs is a matter of domestic tax policy, and countries remain free to tax either gains or returns on those securities where they choose to do so, subject to applicable tax treaties.

^{Table 1.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Foreign Investors

^{Table 1.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Foreign Investors

	Gains	Interest
Non-residents	Exempt (no withholding tax)	Exempt (no withholding tax)

View Table

^{Table 1.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Foreign Investors

	Gains	Interest
Non-residents	Exempt (no withholding tax)	Exempt (no withholding tax)

36. However, when developing the T&Cs, the legal policy aspects related to tax continues to be raised during the course of IMF TA and, therefore, warrants further consideration (for instance, because other debt securities often have tax gross-up provisions such as corporate bonds, usually at the insistence of foreign investors). Although the final form of the T&Cs will be shaped by the specificities of the country concerned, two baseline legal policy lines that could be considered with respect to LCBs comprising government debt securities are as follows (with Box 4 using the case of Australian Treasury Bonds to highlight how these baseline legal policy lines can be expressed in legal drafting):

• Including a provision confirming that payments in respect of the LCBs will be made free and clear of withholding or deduction in respect of taxes. This would also give foreign investors certainty with respect to returns, which becomes particularly important when foreign investors have no other connection with the issuing country other than investing in their LCBs; and

• A provision confirming that, in the event that any payment is made subject to such withholding or deduction, that no additional amounts will become payable by the issuer to the investor (so as to not hamper the government with respect to future tax policy changes). However, it is noted that withholding tax would be very difficult to subsequently impose in practice in any case given FMI preferences (discussed above, and further elaborated in section VIII below) and adverse perceptions of sovereign risk by foreign investors in seeking to do so.

37. The procedural aspects of establishing General T&Cs are also an important issue to consider. A first important legal question is who approves the General T&Cs on behalf of the State? Ideally, the public debt law will establish that the Minister of Finance’s competency to do this. Before approving the General T&Cs, it is good practice to retain specialized local counsel to advise the Ministry of Finance on the drafting and legal policy choices that arise in that context. However, in some jurisdictions (for instance, Ghana), their Constitution requires Parliament/Congress to approve such General T&Cs, which could affect the timing of debt issuance and management operations. Finally, it is similarly good practice to consult with the local investor community, ideally in the context of an established market group. To the extent foreign investors are active, for instance as recognized primary dealers (PDs) (who are primarily considered to be intermediaries, participating in auctions, syndications etc. on behalf of investors), the former could also be included in the consultation.

B. The Form: Dematerialized Securities Holding Legislation

38. It is now generally accepted that the smooth settlement of bond transactions is best served by issuing and circulating those bonds in “dematerialized” form.³⁰ Such dematerialization can be achieved in two ways: (i) by “partial dematerialization, where securities that originally exist in materialized (i.e. bearer or registered) form are “immobilized”;³¹ or (ii) by “full” dematerialization, where securities have no longer any material form.³² As a result of these processes, the securities will for all practical purposes exist only as dematerialized credit balances on securities accounts, held in the books of the CSD or properly licensed custodians. This allows in turn settlement of transactions in the local currency bond market by mere debits and credits of cash and securities accounts, ideally under a “delivery versus payment” mechanism. Such a form of settlement is efficient and safe. At the same time, such dematerialized securities will be held in an “intermediated manner,” that is through a custodian, which gives rise to other risks that must be mitigated.

39. Many countries lack a robust legal framework for dematerialized securities. Traditional securities law (including doctrines such as on negotiable instruments, Wertpapiere or valeurs mobilieres)³³ recognizes three forms of securities: (i) bearer securities that are transferred by manual tradition; (2) registered or “nominative” securities that are transferred by registration in a registry; and (iii) “to order” securities that are transferred by endorsement. In many countries, these forms of securities do not fit very well into the legal framework for “irregular deposit,” which is the general legal framework for the deposit and safekeeping of fungible (tangible) goods. As a result, questions arise as to core issues related to dematerialized securities, such as: what is the exact legal nature of the depositors claims vis-à-vis the depositary (right in rem or right in personam); what is the treatment of those claims in case of insolvency of the depositary; how can the holders of dematerialized securities exercise their contractual or company law rights vis-à-vis the issuer (e.g. voting in a general assembly of shareholders); and which private international law rules will apply to dematerialized securities (lex rei sitae in principle only applies to tangibles)?³⁴

40. Leading jurisdictions have sought to address this problem through the enactment of specific “securities holding legislation” for dematerialized securities. Often, this endeavor was undertaken in the context of the political decision to develop the jurisdiction as a safe haven for securities depositary activity. This can also be achieved through a phased approach. Specifically, in a first phase, countries have allowed the fungibility of bearer securities, and in a next phase enacted legislation allowing the creation and holding of fully dematerialized securities. The most famous example of the first phase was the Belgian Royal Decree Nr. 62, which allowed for the establishment of the Euroclear International Central Securities Depository as a response to the development of the Eurobond market in the 1960s. This Royal Decree subsequently influenced the Luxembourg legal instruments (the latest one being the Law of 1 August 2001 on the Circulation of Securities) that lay the legal foundation for the CEDEL International Central Securities Depository, later renamed into Clearstream, and even Art. 8 of the US Uniform Commercial Code.³⁵ Another good example of a supporting legislative instrument is Regulation (EU) N° 909/2014 of 23 July 2014 on improving securities settlement in the EU and on CSDs, as it sets standards across the EU.

41. Well-designed securities holding legislation will establish a comprehensive framework for the issuance, holding and circulation of dematerialized securities. In most countries, there is a strong argument for establishing full dematerialization, at least for public debt and corporate securities listed on regulated markets. To achieve this, the law will need to: require that those securities be issued in the competent CSD;³⁶ determine which types of financial institutions can act as direct participants in those CSDs; provide for clear mechanisms that protect depositors against the insolvency of their custodian; establish clear rules governing “corporate actions”; and modernize relevant private international law rules.

42. Over the past decades, commendable steps have been taken to codify good practice in respect of securities holding legislation in a number of international legal instruments. The Geneva Securities Convention of UNIDROIT presents a robust and detailed framework for substantive rules on intermediated securities holding. ³⁷ This instrument is complemented by the Hague Securities Convention of the Hague Conference on Private International Law.³⁸ This convention establishes a modern and comprehensive framework for private international law questions pertaining to dematerialized securities. Countries modernizing their securities holding law would be well advised to give due consideration to those legal instruments.

43. From the IMF staff’s experience (which is derived from IMF staff provision of TA), designing an appropriate securities holding legal framework is not an easy endeavor. The main challenge is to develop rules that fit well into the broader legal framework of the country. Especially in countries of the civil law tradition, the Civil Code and commercial law will often include good building blocks that require conceptually relatively minor tweaks (for instance, to ensure that intangible bundles of rights incorporated in dematerialized securities can receive the treatment of tangibles under property and private international law). If, however, legal concepts are introduced from another legal tradition (for instance, trust or nominee structures from common law), such “transplants” could give rise to significant challenges further down the road.

44. The introduction of a dematerialized securities holding regime causes risks that must be mitigated through appropriate legal instruments. Specifically, the adoption of a legally robust private law framework must be complemented with an equally robust public law regulatory framework. That framework should first establish the exercise of custodial services to the public as a regulated activity, reserved to properly licensed financial institutions. In most countries, this activity should only be exercised by banks and brokers. Furthermore, the regulatory framework applicable to the securities holding activities of those financial institutions should require the latter: (a) to adopt a “fit for purpose” securities holding accounting framework; and (b) to segregate at the higher level (typically the CSD) their own holdings from the collective holdings of their clients. These are preconditions for ensuring that investors can recover their securities in case their custodian becomes insolvent. Custodians should also be prohibited from using the securities deposited by their clients, at least without their explicit consent. Finally, a strong supervisory framework to enforce these rules will be the “keystone” to building and maintaining investor confidence.

A. Outright Sales/Purchases

45. In most jurisdictions, the outright sale/purchase of bonds or bills in the secondary market raises few legal issues. Such transactions will typically be governed by the applicable rules of civil or commercial law as well as the rules of the relevant securities settlement system (or CSD). When these transactions are settled “delivery versus payment” in the relevant securities settlement system (see below discussion in relation to settlement finality), the delivery of the purchased security and the payment of the price occur concomitantly, thus reducing legal and credit risks.

B. Financial Collateral Law

46. The use of LCBs as collateral is a central feature of the money, FX and interest rate derivatives markets, and hence a foundation of the broader LCBM. Local currency government bonds constitute the typical collateral in repurchase and derivative transactions under global (e.g. ISDA) or local standardized master agreements.

47. In many countries, the legal framework does not support the use of repurchase agreements and other flexible yet legally robust collateralization techniques. The main problems are the following:³⁹

• Numerus Clausus Principle and Recharacterization Risk: Most legal systems follow the principle that the rights in rem that can be created by contractual parties are fixed (hence the numerus clausus) and cannot be expanded through contractual freedom. While nothing prevents contractual parties to be innovative as long as all goes well, insolvency courts developed the practice of “recharacterizing” non-recognized rights in rem into such existing rights, and subsequently finding that some key requirements for their legal validity have not been complied with, thus resulting in their non-enforceability. This risk is particularly acute for the use of ownership rights as a collateral technique, which is the case of repurchase agreements and transfer of title arrangements used under derivative agreements.

• Claw Back Rules: Many jurisdictions include so-called “claw back” or avoidance rules, which allow insolvency practitioners or courts to take action to return payments and asset transfers made by an insolvent party prior to its insolvency. These rules typically consist of: (i) rules related to preferential payments made during a “suspect period” of often 6 months or a year; and (ii) fraudulent payments which can be undone often without time limit (the actio pauliana). These rules may hinder the use of substitution and margin calls. Substitution allows the collateral provider contractually to substitute one security with another during the duration of the collateral contract. Margin calls are a core tool in modern financial risk management and give the collateral taker the contractual right to request the delivery of additional securities if the overall value of the collateral portfolio has fallen (typically after a “marking to market”) below a contractually stipulated threshold. In both cases, “isolated” deliveries of securities could be declared unenforceable if they occur during the suspect period preceding the insolvency of the collateral provider.

• Risks to Close-Out Netting: Traditionally, insolvency laws include the principle that set-off and netting are not enforceable against the insolvent estate following the occurrence of a defined ‘insolvency event.’ Furthermore, the opening of an insolvency procedure typically gives rise to a statutory moratorium on creditor action without the permission of the court. This will be problematic in the context of financial collateral agreements. These agreements typically include “close-out netting” provisions that allow one party, in case of default (as defined) by the other party, to close out, i.e., to terminate all outstanding transactions covered by the agreement, calculate the exposures under each transaction, net all mutual exposures, and satisfy the resulting net claim by enforcing the financial collateral. Non-enforceability of netting makes such provisions non-operative, resulting in the loss of a linchpin feature of capital markets risk management.

48. To mitigate those legal risks, most countries need to adopt so-called “financial collateral” legislation. Formally, this type of legislation is sometimes combined with settlement finality legislation (see below) and/or (amendments to) legislation that provides explicit legal recognition to derivative transactions in a single instrument. Substantively, this legislation seeks the following outcomes:

• Explicit recognition of the legal validity and enforceability of repurchase and other forms of transfer of title arrangements by way of security, thus removing recharacterization risk;

• Protection of collateral substitution and margin call during suspect periods (except for explicit fraud);

• Modernization of pledge rules, especially in view of cash collateral and dematerialized securities, for instance by allowing enforcement without court order (thus departing from the widespread prohibition of the pactum commisorium) and the transfer of ownership rights over pledged securities from pledgor to pledgee (recognition of the pignus irregulare);

• Protection of enforceability of close-out netting provisions upon insolvency; and

• Modernization of private international law principles in respect of the collateralization of dematerialized securities.

49. This exercise is underpinned by a wide body of international standards and good practice. UNIDROIT has issued the abovementioned Geneva Securities Convention and “Close Out Netting Principles,”⁴⁰ which provide excellent benchmarking for law reform efforts. The same is valid for the equally abovementioned The Hague Securities Convention. The EU Financial Collateral Directive is an example of good practice of the legal design of a modern financial collateral framework.

C. Central Bank Monetary Policy Legal Framework

50. The legal framework governing the central bank’s monetary policy implementation is an important application of the financial collateral law. Its purpose is to regulate the manner in which the central bank enters into Lombard and other “open market” operations, and other financial transactions, with a view to influence monetary conditions, and thus pursue its price stability objective. The legal nature of this framework is in most countries dual: the general principles are established in the central bank law, whereas the detailed rules are laid down in a contractual type of legal instrument (“general terms and conditions”), although some countries instead have recourse to a regulatory instrument.

51. The degree to which the monetary policy legal framework will allow counterparties to collateralize LCBs with the central bank will have a major impact on the attractiveness of those bonds for banks—the typical central bank counterparty—in particular. It is well understood that, in most countries, this will not be a problem for government bonds, as these are the collateral of choice for most if not all central banks. For corporate bonds this is however different. The design of a risk management framework is certainly a holistic exercise that raises complex policy issues. In that respect, it is submitted that the acceptance, in principle, of local currency corporate bonds that meet a certain standard (e.g., a minimum rating) in terms of credit risk, combined with strong risk management measures catering for their particular nature (e.g. their lower liquidity), is not inherently irreconcilable with sound risk management, and thus deserves consideration. From a legal policy perspective, this pleads for legal frameworks that support the wide circulation and broad use of corporate bonds, including as financial collateral.

52. Another important aspect of the monetary policy legal framework is the repurchase agreement that is used by the central bank. Many central banks prefer to document their repurchase agreements with monetary policy counterparties through a bespoke, local law-governed master agreement, rather than by internationally accepted master agreements (e.g., the GMRA). Often, that local law master agreement will become de facto or de jure the local market standard, including for pure inter-bank transactions without central bank involvement. Thus, the effort made by the central bank to design a well-structured and balanced master repurchase agreement will have broader developmental effects on the money and local currency bond markets. The same conclusion applies mutatis mutandis for securities lending agreements.

Objectives of tax law reform of LCBMs

54. When assessing whether the legal framework for taxation is appropriate, the key objective is to identify and remove tax impediments to the development and efficient working of the primary and secondary LCBMs. This typically requires the careful design and implementation of suitable and accommodative tax law reforms that focus on both: (i) the supply side of LCBs (dealing with the tax treatment of the LCBs themselves in both the primary and secondary markets); and (ii) the demand side of LCBs (dealing with the effective and efficient alignment of that tax treatment between key institutional investor groups, including mutual and investment funds, to encourage investment and liquidity in LCBMs). Box 5 below summarizes the objectives of both these supply side and demand side tax law reforms.

^{Box 5.}

Objectives of Supply Side and Demand Side Tax Reforms

Supply side objectives: Facilitate investment and issuance decisions relating to LCBs (e.g. by enhancing the development and efficient working of the primary and secondary markets). Identify and remove tax biases against investing in LCBs (e.g. when compared to other investment products such as other bonds or bank deposits). Minimize inefficiencies and tax law distortions (e.g. financial transactions taxes, non-standard third-party (withholding) tax obligations etc.)

Demand side objectives: Attractive to investors (e.g. channel savings into investment). Must not put investors in a worse situation than if they had invested directly (e.g. when investing through mutual or investment funds)—and often concessionary for portfolio investors. Need to understand relative tax efficiencies between channels/investment options.

View Table

Supply side objectives: Facilitate investment and issuance decisions relating to LCBs (e.g. by enhancing the development and efficient working of the primary and secondary markets). Identify and remove tax biases against investing in LCBs (e.g. when compared to other investment products such as other bonds or bank deposits). Minimize inefficiencies and tax law distortions (e.g. financial transactions taxes, non-standard third-party (withholding) tax obligations etc.)

Demand side objectives: Attractive to investors (e.g. channel savings into investment). Must not put investors in a worse situation than if they had invested directly (e.g. when investing through mutual or investment funds)—and often concessionary for portfolio investors. Need to understand relative tax efficiencies between channels/investment options.

Multi-step approach to achieving tax law reform of LCBMs

55. Many countries have an inadequate tax law framework governing the treatment of LCBs, which results in material tax impediments to the development and efficient working of the primary and secondary LCBMs. Designing and implementing a set of law reforms to achieve an effective and efficient tax law framework governing LCBs typically requires a multi-step approach. This ideally involves undertaking a diagnostic review of the existing tax law framework of the country that is comprehensive (i.e. covering both substantive and administrative provisions) in order to: (a) identify existing impediments and gaps in that framework as it relates to LCBs, with specific regard to international good practices; and (b) develop law reform options to address those impediments and gaps. It is also important that the tax law framework provides certainty with respect to all key primary and secondary market transactions for all key investor classes. For example, on the supply side, this should include not only the tax treatment of the LCBs themselves in the hands of all key classes of domestic and foreign investor, but also the tax treatment of secondary market transactions over LCBs by each of those investors which will become critical for liquidity, hedging and market-making etc. Similarly, on the demand side, it is important to achieve an effective and efficient tax alignment of LCBs between key institutional investor groups— including mutual and investment funds—in order to also encourage investment and liquidity in LCBMs.

56. Countries should develop their own individual tax law reform plan in a systematic and coordinated way, so that it is appropriately integrated with their national capital market development plan. The legislative action to be taken will ultimately depend on each individual country’s legal tradition and baseline tax law framework, including its underlying fiscal and tax policy settings.

A. Supply side treatment—primary and secondary market

57. It is important to understand the scope of the tax treatment issues that should be addressed by the tax law framework. As a first step, it should address each key investor class from a supply side perspective (dealing with the treatment of the LCBs themselves). Box 6 provides some high-level guidance in this regard.

^{Box 6.}

Tax Treatment Issues to be Addressed by the Tax Law Framework Supply Side

Taxation of LCBs themselves:

• Primary market:

  • Address both local and foreign investors; and

  • Treatment of returns (e.g. interest, discount etc.).

• Secondary market (important for hedging, liquidity etc.):

  • Taxation of gains (e.g. on sale), including sale amounts attributable to accrued interest (often treated as interest if tax favored compared to trading/capital gains);

  • Taxation of repos (see Box 8);

  • Taxation of securities lending (similar considerations to repos);

  • Treatment of financial collateral (similar considerations to repos); and

  • Taxation of derivatives (increasing trend towards mark-to-market approaches).

58. A key objective of well-designed supply side tax measures is to remove tax biases. This supply side objective focuses on dealing with the treatment of the LCBs themselves (the investment supply) and should have specific regard to the treatment vis-à-vis other investments (other investment supplies). The idea is to identify and remove tax biases which might make create a bias in favor of investing in other financial instruments and against LCBs. This step is more about achieving, at a minimum, tax neutrality. For example, having LCBs taxed at a higher rate when compared to other alternative financial instruments would create a bias against investing in LCBs. Another (common) example would be if a gain on the secondary sale of a LCB was subject to tax at the ordinary income tax rate (e.g. 30%), rather than the reduced rate applicable to interest income (e.g. 15%) in circumstances where that gain is solely attributable to accrued interest (for instance, which can arise, as discussed below, where the secondary sale occurs between two coupon payment dates). This would also negatively impact on secondary market activity and hence liquidity (so secondary market issues are also discussed below as part of the supply side tax treatment issues in this Working Paper).

59. When designing the necessary supply side tax law reforms, consideration also needs to be given to the legal modalities relating to the issuance and trading of LCBs and associated FMIs, given an integrated tax law framework requires consistency with the country’s overarching legal infrastructure. As discussed above, for example, in the context of facilitating foreign investment, interest withholding tax and capital gains/profits tax concessions/exemptions in relation to returns and gains on LCBs that are consistent with international common practice often become necessary to achieve critical investment links between LCBMs and international FMIs. In this regard, more generous tax treatment often applies for non-residents investing in LCBs (otherwise FMIs will remain unprepared to establish a link with many small and underdeveloped capital markets). However, the ultimate tax treatment of a country’s LCBs is a matter of domestic tax policy, having regard to their capital markets development plan.⁴¹ The position with respect to local investors is more complex (and those investors ideally should be taxed on the grounds on equity and fairness between domestic taxpayers, subject to any constitutional constraints with respect to treating non-residents more generously), but relief for foreign investors on LCBs (and, where appropriate, other publicly issued securities) is common international practice for a number of reasons (see also section VI above). For present purposes, a baseline tax treatment reflecting common international practice with respect to the treatment of LCBs comprising government debt securities is set out in (Table 2) below.

^{Table 2.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Local and Foreign Investors

* Subject to domestic tax policy positions and capital markets development plan.** This tax treatment is sometimes extended to other publicly issued debt securities (a discussion of which is beyond the scope of this Working Paper), but when doing so the qualifying conditions should be carefully circumscribed, particularly with respect to interest payments to non-residents to safeguard against abuse.

^{Table 2.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Local and Foreign Investors

Investors	Gains	Interest
Residents	Tax*	Tax*
Non-residents	Exempt** (no withholding tax)	Exempt** (no withholding tax)

* Subject to domestic tax policy positions and capital markets development plan.** This tax treatment is sometimes extended to other publicly issued debt securities (a discussion of which is beyond the scope of this Working Paper), but when doing so the qualifying conditions should be carefully circumscribed, particularly with respect to interest payments to non-residents to safeguard against abuse.

View Table

^{Table 2.}

Baseline Tax Law Treatment of LCBs comprising Government Debt Securities for Local and Foreign Investors

Investors	Gains	Interest
Residents	Tax*	Tax*
Non-residents	Exempt** (no withholding tax)	Exempt** (no withholding tax)

* Subject to domestic tax policy positions and capital markets development plan.** This tax treatment is sometimes extended to other publicly issued debt securities (a discussion of which is beyond the scope of this Working Paper), but when doing so the qualifying conditions should be carefully circumscribed, particularly with respect to interest payments to non-residents to safeguard against abuse.

60. If seeking to tax investors on either their LCB gains or returns, it is important that the tax treatment is clear and unambiguous under the tax law. Navigating this tax law design complexity to achieve clear and unambiguous tax treatment often becomes difficult and reflects why an established international practice has emerged of not seeking to tax foreign investors on their LCB gains, together with providing appropriate interest withholding tax concessions in respect of coupon payments made to foreign holders, given both positions also represent the approach preferred by FMIs (as discussed above). To give a sense of the tax law design complexity when seeking to tax foreign investors on their LCB gains (even putting aside the more complex collection and enforcement difficulties), certainty would be required with respect to the following: (i) whether the gain is characterized as a revenue gain or capital gain, which is a relevant distinction made by many domestic tax systems (as a different tax treatment or tax rate can apply); (ii) the tax timing of the gain (which can differ depending on the structure of the LCB itself and how the gain is realized); and (iii) whether the gain has a local source (as foreign investors are typically only taxable on locally sourced gains under established international tax norms). Greater certainty is achieved when all these aspects are prescribed by the tax legislation (which should be the preferred approach), rather than, for example, the courts (for instance, in the absence of having a statutory definition of “source”, many common law countries have left the courts to develop the principles for determining the “source” of gains, which can be particularly problematic when outdated common law source rules are applied to fast moving and innovative capital market transactions). In the absence of clear tax rules (and often the best designed tax laws are still not perfect), it can become difficult for a foreign investor in a LCB with no other presence in the country that issued the LCB to determine their tax treatment with the certainty required to support their investment demand. The complications multiply when a local or foreign intermediary is used by foreign investors to manage assets or settle transactions (which is also typically the case) because their use can, in turn, in the absence of clear tax rules give rise to a taxable presence for the foreign investor in the country of the intermediary (and also a local source for the resulting gain where a local intermediary is used which can expose it to unintended tax consequences). The complexity can be more easily resolved where a tax treaty allocates taxing rights and source. However, where no tax treaty is applicable, the position remains complex and has led to the practice of not seeking to tax foreign investors on their LCB gains.⁴²

61. In terms of the tax treatment of LCB returns, “interest” should ideally be defined broadly in the tax law. This reflects the fact that there is considerable flexibility on international monetary markets as to how financial instruments may be structured. The definition should capture not only ordinary notions of “interest” (e.g. coupons on LCBs) but also certain amounts attributable to, or functionally equivalent to, interest. Clearly defining these amounts can also be important for the imposition or non-imposition of non-resident withholding tax, as well as providing certainty in relation to the tax treatment of secondary sales of debt securities. Examples of amounts that are functionally equivalent to interest include an amount payable for the time value of money under a derivative financial instrument (such as a swap) and a payment of defaulted interest by a guarantor. Additionally, several countries are seeking to develop their domestic Sukuk markets to tap Islamic financial markets by issuing a variety of Sukuk structures and maturities⁴³ making them potentially promising for LCBM development.⁴⁴ As a general rule, the tax treatment of income from Islamic financial transactions should also be aligned with that of conventional financial transactions that they are economically equivalent to. Capturing amounts that are functionally equivalent to interest in nearly all cases will achieve better neutrality of tax treatment between similar financial instruments.

62. Further, when a debt security is sold between interest payment dates, part of the sales price will typically represent interest accrued to the date of the sale. A common issue is that the tax law does not differentiate between gains on the sale of debt securities (which can be subject to profits tax, particularly for resident investors) and that part of the sales price which is attributable to accrued interest (which could be treated as interest). If not appropriately aligned, anecdotal evidence in a number of countries suggests that parties to a secondary sale of debt securities could seek to settle the transaction on interest payment dates, or otherwise attempt to apportion coupon amounts between those parties in order to avoid adverse or uncertain tax outcomes (e.g. higher tax rates on capital gains when compared to interest income which may be accrued in the capital gain). This leads to complexity and inefficiency in ordinary market transactions.

63. It is common international practice in major financial centers to treat as interest that part of the sales price that represents interest accrued to the date of the sale. Under this treatment, the seller would report part of the sales price as interest income, and the buyer would treat the interest amount subsequently received as a return of capital investment, reducing their tax basis in the relevant debt securities.

64. Further, a deep and more mature capital market will offer a suite of more complex bond offerings and secondary market transactions relating to LCBs. These transactions also eventually become an integral part of the capital market and financial system. Therefore, it is important that the tax law framework provide clear, internationally comparable, rules for determining the tax treatment of all other returns from LCBs (e.g. discounts, premiums and other maturity amounts). Similarly, the tax law framework should also provide clear, internationally comparable, rules for determining the tax treatment of the typical secondary market transactions over LCBs that will be entered into by each key class of domestic and foreign investor (such as the tax treatment of gains on secondary sale for both retail and institutional investors, as well as repurchase transaction, securities lending, financial collateral, and derivative transactions for institutional investors) which is critical for liquidity, hedging and market-making.

65. The tax law framework should also embody appropriate rules-based integrity provisions to combat tax structures and transactions considered abusive or otherwise producing inappropriate policy outcomes These are often necessary to combat: (i) bond washing which consists of selling a bond just before it pays a coupon and then buying it back once the coupon has been paid to realize a tax-free capital gain or avoid withholding tax on the coupon; and (ii) an inappropriate deferral of tax under deeply discounted securities by taxing them on an accruals basis. Further, various secondary market transactions (such as repos and securities lending – discussed below) may give rise to unacceptable tax avoidance opportunities in different ways, which can also arise from specific interactions or gaps between tax rules. Sometimes these opportunities are closed by simply forbidding these transactions for certain types of taxpayers (for example, for N-accounts in the Belgian X/N clearing and settlement system). In other cases, they require specific legislative rules to combat them (for example, eliminating any potential double dip of tax credits through manufactured dividends).

66. It is also typical for an advisory, placement and asset management industry to develop in relation to LCBs, and, over time, LCBs with more complex design features will develop and other securities, financial products and instruments will also become available in the financial market. Putting in place a more comprehensive tax law framework as it relates to financial markets upfront will ensure that the framework is equipped to deal with more sophisticated transactions and provide certainty to investors, once those markets deepen in the relevant emerging market and developing economy. For example, indexed bonds often develop after more vanilla LCBs, so the tax law framework should consider the likely evolution in LCB design features upfront to ensure certainty of tax treatment with respect to both tax characterization (e.g. confirming whether the indexed component of the return is to be treated as interest income rather than capital gain) and tax timing (e.g. whether or not accruals taxation could apply—particularly where the LCBs are also capital-indexed). In each case, complexity or uncertainty of tax treatment can materially and adversely impact investor appetite. Further, more complex and highly structured bonds can potentially transform a legal form debt instrument into one that, in substance, more closely resembles equity (e.g. use of convertible features adopted for solvency reasons). Many domestic tax systems have developed rules to determine whether the instrument issued constitutes debt or equity for tax purposes to provide greater certainty and appropriateness of tax treatment, although these rules are typically more relevant for non-government issued debt.

67. As noted above, often the existing tax law framework is capable of dealing with more vanilla transactions such as the issuance, buying and selling of LCBs, but does not contain any provisions to provide certainty in relation to the tax treatment of more complex issuances or secondary market transactions. The following discussion will focus on ensuring an adequate tax law framework for the following secondary market transactions:

• Derivatives;

• Securities lending; and

• Repos.

Derivatives

68. Derivative markets are an integral part of the LCBMs. Derivatives also play an increasingly important role in modern financial markets. Derivatives typically include forward contracts, futures, swaps, and options and combinations of these. A derivative contract is an agreement between two counterparties (i.e. a buyer and a seller), which specifies how the value of the contract evolves over time (e.g., by reference to an underlying object). As noted above, a derivative is commonly documented using an industry standard master agreement published by the International Swaps and Derivatives Association Inc., (ISDA) (ISDA Master Agreement) and Schedule, and an ISDA Credit Support Annex or similar document (CSA). The ISDA Master Agreement, Schedule and CSA are collectively referred to as the ISDA.

69. Under the ISDA (and depending on the nature and terms of the underlying derivative arrangement), certain periodic and final balancing payments will typically become payable between the counterparties. Under the ISDA’s CSA, or similar arrangement, one counterparty (e.g. buyer, or vice versa) will typically be required to provide cash or securities to the other counterparty (e.g. seller, or vice versa) as financial collateral in respect of any mark-to-market (MTM) exposure against the relevant counterparty under the derivative.

70. Many emerging markets and developing economies jurisdictions operate under a choice of law principle for derivatives, such that local counterparties are free to enter into an ISDA that is governed by foreign law, particularly where the ISDA is being entered into with a foreign counterparty. Parties could, for instance, enter into a standard collateral document governed by New York law (NY Law CSA) or one prepared for use under English law (English Law CSA). From a tax law perspective, the choice of foreign law itself is generally not that material. However, to the extent that the use of a document governed by foreign law affects the legal characterization of a relevant transaction under the relevant ISDA agreement, the tax law framework would need to address this. For example, on the financial collateral side, English Law CSAs typically give rise to an absolute transfer of title of the collateral, whereas NY Law CSAs generally give rise to security interests only (similar to pledge). The domestic tax law will need specific rules to accommodate both of these possibilities to achieve neutrality between them. Where there is an absolute transfer of title of financial collateral, then the arrangement typically operates in a similar way to securities lending transaction and therefore those rules (discussed further below) also become important to support derivative transactions (by, amongst other things, disregarding both the transfer and return of the financial collateral for the collateral giver). Alternatively, where the transfer of the financial collateral gives rise to a mere security interest only, then it is common for the tax law to already not treat the transfer as a disposal (which is similar to the existing tax treatment for a home owner when taking out a mortgage on their home, which does not result in a disposal of that property to the bank mortgagee for tax purposes, even if title to the property were to be transferred to the bank under that mortgage for security registration purposes).

71. There is a trend internationally to treat the derivative transaction itself (as distinct from the financial collateral supporting it) for tax purposes in the same way as they are treated for financial accounting purposes in accordance with IFRS. This is particularly so for financial institutions who are the typical counterparties that enter into initial secondary market transactions over LCBs. Under a tax law model that aligns the tax treatment of derivatives with their accounting treatment, positive movements in the value of a derivative contract (i.e. fair value or MTM movements) would be subject to tax consequence each year, even if the gain and loss are unrealized. There is a trend towards this treatment in a number of financial centers (see, for example, recent derivatives reforms in the U.K., and proposed reforms in the U.S. etc.).

72. Jurisdictions that have adopted this model for derivative transactions will often consider whether to also adopt some (elective) exceptions to MTM taxation to smooth out the impact on certain hedges etc. Under hedging strategies, financial institutions will often try to reduce or mitigate the financial effects from risks that could impact upon the institution’s business. The company will often enter into derivative contracts which will be structured to minimize these risks. The hedged item is the asset, liability or future transaction whose risk is being mitigated. The broad effect of these exceptions is to disregard the fair value or MTM movements on the derivative and instead to bring profits and losses into account for corporate income tax purposes in line with the hedged item.

73. In the absence of MTM taxation or where that treatment does not otherwise apply (e.g. because it only applies to financial institutions), then the derivative transaction is typically taxed on a realization basis. This would mean that gains or losses arising from those derivation transactions are ordinarily brought to account for tax purposes when the respective periodic and final balancing payments are payable/made between the counterparties (e.g. at relevant settlement times). Given the flexibility within which derivatives can often be settled and the possible arbitrariness of tax consequences that could follow, authorities should be vigilant for signs of abuse when a realization basis applies for tax purposes.

Securities lending arrangements and financial collateral

74. Securities lending transactions are essential to the liquidity of the capital markets and to facilitate the provision of hedging strategies to investors. While similar to a repo in some respects, there are important legal and tax law differences.

75. The essential features of a securities lending agreement (SLA) are:

• The “lender” agrees to transfer securities to the “borrower” in return for the promise of the “borrower” to return unascertained identical (i.e. equivalent but not the very same) securities, either on a fixed future day or, more commonly, on demand (but with a maximum term of say less than 12 months). Transactions are typically affected under the standard form Global Master Securities Lending Agreement (GMSLA). In respect of financial collateral arrangements under derivatives, the transaction could be affected under an industry standard CSA, so these rules become important to also support derivative transactions (as noted above).

• As in the case of a repo, all transfers of securities pass absolute title to those securities to the transferee. There is thus no “loan” of securities. These features are the same as a mutuum under Roman law.⁴⁵

• Invariably, the “borrower” must, directly or indirectly, provide the “lender” with a fee, which is usually calculated or earned in a manner similar to interest.

• In theory, a securities lending transaction can be unsecured. However, in practice this is rarely (if ever) the case between arm’s length parties. The security can be provided, broadly, in one of three ways:

  • By the borrower providing an irrevocable standby letter of credit or guarantee from a creditworthy institution;

  • By the borrower furnishing cash collateral;

  • By the borrower providing non-cash collateral (e.g. equities or debt securities such as LCBs) under what is effectively a parallel securities loan, under the same SLA, (in that absolute title to the collateral securities passes to the “lender”, who is obliged to deliver identical (but not the very same) ones on the return of identical original securities by the “borrower”).

• If a record date for the payment of a dividend, coupon or other distribution occurs during the period of the securities borrowing, the borrower must typically make a manufactured payment to the lender of the relevant securities equal to the amount of the relevant distribution.

76. In the absence of specific tax law provisions, the following tax consequences generally then arise:

• The lender is treated as having disposed of the securities that were lent at the time the securities lending arrangement was entered into; and

• That disposal could result in a taxable gain or loss for the lender in respect of the securities that were lent under the securities lending arrangement, based on the market value of the relevant lent securities at the time the original securities lending transaction was entered into.

77. Many jurisdictions that tax capital gains on transfer of securities implement specific provisions relating to securities lending arrangements. Those specific provisions applying to a securities lending arrangement can operate as follows:

• The lender is essentially treated for tax purposes as though it has never disposed of the securities when they are lent under the arrangement, but the lender is taxable on the fee income earned.

• Any gains or losses that would otherwise be realized by the lender on the transfer of securities to the borrower and the later acquisition of equivalent securities under a securities lending arrangement are ignored.

• The return of equivalent securities does not of itself result in any gain or loss to the borrower. However, the borrower would make an overall profit or loss from the arrangement to the extent that the value of the equivalent securities returned to the lender is less that the value of the borrowed securities sold by the borrower.

• The borrower would include in their gross income the receipt of any dividend, coupon or other distribution but should deduct the manufactured payment payable to the lender, thus leaving the borrower in a tax neutral position.

• The manufactured payment will be included in gross income of the lender, but that payment can be treated as if it were a dividend or interest on the securities (as the case may require).

78. A sample set of legislative provisions are set out in Box 7 below:

Repo transactions

79. Repurchase agreements (repos) have long been common in both the domestic and international bond markets and are essential in maintaining liquidity in those markets. Typically, such transactions have been affected under a Global Master Repurchase Agreement including associated schedules and annexes (the GMRA). However, as discussed above, repo transactions with a central bank are sometimes also affected under a bespoke local law governed master agreement, which may become—the de facto or de jure—local market standard.⁴⁶

80. A repo has the following essential features:

• One party (Seller) agrees to sell unascertained securities to the other (Buyer) for a fixed cash price (equal to approximately the current market value of the securities or between 100% and 105% thereof), with settlement taking place almost immediately. This is effectively a spot sale of the securities.

• Simultaneously, under a related transaction, the Buyer agrees to sell to the Seller unascertained identical (i.e. equivalent but not the very same) securities, either on a fixed future date or on demand, for cash. This is effectively a forward sale agreement in respect of unascertained equivalent (i.e. unidentifiable or non-specific) securities. The purchase price under the forward agreement is a function of the purchase price under the spot sale. If, say, the market rate of interest for a cash deposit in the relevant currency (say USD) was 6% pa, then the re-purchase price is calculated as initial purchase price under the spot sale, times 106%, times number of days between the date of completion of the spot sale and the date of completion of the re-purchase agreement, divided by 365 (or sometimes 360). In other words, the Buyer effectively gets back their initial purchase price under the spot sale plus an amount calculated in the same manner as, and equivalent in substance to, interest.

• All transfers of securities pass absolute title to those securities to the transferee.

• If the repurchase agreement straddles a record date for the payment of interest or another kind of distribution on the security, then, on the income payment date, the Buyer must pay an equal amount to the Seller. However, under a variation to the arrangement, instead the repurchase price is reduced by approximately the same amount. Such a variation is called a “buy/sell” transaction, rather than a “repo”.

• The principal difference between a repo and a securities lending transaction relates to the character of any cash which passes from the borrower to the lender at the time when the securities are “lent”:

  • Under a securities lending transaction, the cash collateral is in the nature of a security deposit, to facilitate the exercise by the lender of a right of set-off, or netting, on default by the borrower.

  • Under a repo, the cash is in the nature of a purchase price. The initial Seller does not have to be able to set-off or net in order to retain the cash, in the event of the initial Buyer’s default and insolvency.

81. Like the case with respect to securities lending transactions (discussed above), a tax law framework for repo transactions could be distortionary if it is structured based on the legal structure of the repo (sale and repurchase) rather than its economic substance (collateralized borrowing). It is desirable to treat income and gains from, and the costs of, repo transactions as interest income and expenses respectively, rather than as giving rise to capital gains and losses, and also to ensure transaction amounts are free from withholding tax. Transaction taxes on repos (or securities lending transactions) are also not helpful in developing capital markets. Box 8 summarizes the key tax considerations relating to repo transactions.

82. A sample set of legislative provisions are set out in Box 9 below (which largely replicate those relating to a securities lending transaction, but as modified to reflect the different characteristics of a repo):