## Local Currency Bond Markets Law Reform: A Methodology for Emerging Markets and Developing Economies (Working Paper), sections I–II and selected later sections ## Source details **Canonical URL:** [Local Currency Bond Markets Law Reform: A Methodology for Emerging Markets and Developing Economies (Working Paper), sections I–II and selected later sections](https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020258-print-pdf.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2020/english/wpiea2020258-print-pdf.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2020/english/wpiea2020258-print-pdf.pdf.json) --- ### Purpose, scope, and IMF role - Purpose: - Outline a strategically anchored methodology to strengthen legal and tax foundations for development of local currency bond markets (LCBMs) and assist authorities in designing a medium-term law reform plan anchored in a broader capital market development strategy. - Focus primarily on government securities while covering relevant aspects of corporate bond markets; does not address company law reform or judicial reform needs. - Emphasizes that sequencing of reforms is “critical and challenging” and roles of relevant stakeholders (mainly the government and the central bank) must be well-defined. - IMF mandate and role: - IMF interest in LCBMs grounded in promotion of “exchange stability” (Article I of the IMF’s Articles of Agreement) and surveillance under Article IV. - IMF staff provides general policy advice on debt management and TA on legal and tax instruments; coordinates with other IOs and TA providers. - Macroeconomic benefits cited: - Potential benefits include: (i) increase of a country’s ability to absorb volatile capital flows and intermediate them efficiently; (ii) reduction of reliance on foreign borrowing and currency mismatch risks; (iii) contribution to reduction of current account imbalances; (iv) mitigation of need for large precautionary reserve holdings; (v) improvement of macroeconomic policy capacity to respond to shocks (G20 Cannes Summit, 2011). ### Analytical framework and sequencing - Six building blocks for LCBM development: - (i) Money Market; (ii) Primary Market; (iii) Secondary Market; (iv) Investor Base; (v) Financial Market Infrastructure (FMI); and (vi) the Legal and Regulatory Framework. - Sequencing of market development (stages): - Stage 1 — FX: organize FX market and well-sequenced opening of current and capital accounts. - Stage 2 — Debt Securities: fixed income securities, including LCBs (government bonds and bills). - Stage 3 — Secondary transactions over debt securities: outright sales, derivatives, securities lending, repos. - Stage 4 — Equity securities: common stock and related derivatives (beyond scope of paper). - Pyramid framework for sequencing law reforms: - Base layer: enforceability of contracts, property rights, insolvency, company law, judiciary quality. - Middle layer: financial audit/reporting, tax, market access, FMIs (settlement finality, custody, dematerialization), monetary policy, banking/insurance/pension regulation. - Top layer: securities regulator framework, access to regulated markets, conduct rules, continuous obligations. - Key sequencing principle: - Legal components are interdependent; higher layers require functioning underlying layers. Focus first on base and middle layers where international best practice may be aspirational. ### Legal objectives for LCBM development - Legal framework should: - Clarify legal status of dematerialized securities. - Shield investors from insolvency of custodians. - Prohibit and sanction custodian/intermediary misconduct (misuse of client assets, market manipulation, insider trading). - Govern both primary and secondary markets in government securities. - Authorization to issue debt instruments: - Good practice: explicit legislative authorization for State to issue bonds/bills (public debt law or law of public debt securities). - Public debt law should include longer-term debt management objectives, requirement for a debt management strategy, and an annual evaluation submitted to Parliament/Congress. - Debt management strategy elements: planned borrowings to promote market development; build yield curve by regular supply; progressive extension of maturities; consolidation into liquid benchmarks. - Contractual framework (General Terms & Conditions — T&Cs): - Essential provisions: choice of law (issuer law), dispute settlement (local courts exclusive), definitions, scope, issuer identification, currency, CSD/legal status (dematerialization), payment mechanics, day count conventions, tax clause (withholding/gross-up approach), amendments, governing law and dispute resolution. - Typical policy: T&Cs should establish bonds governed exclusively by law of the issuer and disputes in local courts; contractual gross-up clauses should generally be resisted. ### Dematerialization and securities holding legislation - Dematerialization approaches: - (i) partial dematerialization (immobilization of materialized securities); - (ii) full dematerialization (no material form). - Well-designed securities holding legislation should: - require issuance in a competent CSD; - determine eligible direct participants; - protect depositors against custodian insolvency; - establish corporate action rules; - modernize private international law rules. - International instruments to consider: - Geneva Securities Convention (UNIDROIT) and Hague Securities Convention. - Regulatory complements: - Custodial services as regulated activity reserved to licensed institutions; segregation at CSD level; prohibition on custodians using client securities without consent; strong supervisory framework. ### Financial collateral, netting, and settlement finality - Main legal problems in many jurisdictions: - Numerus clausus and recharacterization risk for novel rights in rem. - Claw-back (avoidance) rules during suspect periods (e.g., 6 months or one year) and for fraudulent payments. - Non-enforceability of close-out netting and statutory moratoria on creditor action upon insolvency. - Substantive objectives for financial collateral legislation: - Recognize legal validity and enforceability of repos/transfer-of-title arrangements. - Protect collateral substitution and margin calls during suspect periods (except fraud). - Modernize pledge rules for cash collateral and dematerialized securities, allow enforcement without court order, and recognize ownership transfer mechanisms (pignus irregulare). - Protect enforceability of close-out netting upon insolvency. - Modernize private international law for collateralization of dematerialized securities. - Settlement Finality Legislation (SFL) objectives: - Ensure payments and securities transfers effected before insolvency notification are final. - Define personal scope (which systems and institutions are covered). - Override zero-hour rule and claw-back rules for covered participants and infrastructures. - Declare validity and enforceability of netting and set-off in recognized infrastructures. ### Central bank and fiscal agency arrangements - Institutional roles: - State/MoF: principal issuer and determines market structure; may evolve toward a public debt management office. - Central Bank: fiscal agent (payment of principal/coupon), major LCB user in monetary policy, operator/overseer of critical FMIs (payment and securities settlement). - Market Authority: promotes fair/transparent markets, applies market integrity rules to government debt markets. - CSD: critical in settlement; interaction with central bank payment system essential. - Fiscal Agency Agreement: - Should specify central bank roles as banker to the State, depositary roles, auction organization, and payment procedures for coupons and principal; publication recommended for market clarity. - Monetary policy legal framework: - Should permit counterparties to collateralize LCBs with the central bank; corporate bonds may be accepted if standards (e.g., minimum rating) and risk management measures exist. - Local law master repurchase agreements often become market standards; central bank master repo agreements have developmental effects. ### Tax framework objectives and multi-step reform approach - Tax objectives: - Encourage investment and liquidity in bond markets; ensure appropriate treatment of repo transactions; support primary and secondary markets; provide clear tax treatment for each investor class including foreign investors; conform to international good practices. - Supply-side objective: remove tax biases between LCBs and alternative instruments; clarify taxation of returns (interest, discount, gains) and secondary transactions (repos, securities lending, derivatives). - Demand-side objective: align tax treatment across institutional investor groups (investment/mutual funds, pension funds, insurance) to attract savings. - Recommended multi-step tax law reform: - Undertake comprehensive diagnostic review of substantive and administrative tax provisions. - (a) Identify impediments and gaps versus international good practices. - (b) Develop law reform options coordinated with national capital market plans. - Baseline tax treatment for government LCBs cited: - Gains: Exempt (no withholding tax) - Interest: Exempt (no withholding tax) - Legal modalities and foreign investors: - Facilitation often requires withholding tax and capital gains concessions/exemptions for non-residents to link with international FMIs; ultimate tax policy remains domestic decision. - Defining “interest”: - Tax law should define interest broadly to capture coupons and amounts functionally equivalent to interest (e.g., swap payments, defaulted interest by guarantor) and align sukuk treatment with economically equivalent conventional instruments. - Accrued interest and secondary sales: - International practice: treat portion attributable to accrued interest as interest for seller and adjust buyer’s tax basis accordingly to preserve neutrality. ### Integrity rules and anti-abuse measures - Combat abuses such as bond washing and inappropriate deferral via accruals rules for deeply discounted securities. - Upfront comprehensive tax rules recommended to prevent avoidance in repos, securities lending, and interactions across rules. - Examples of regulatory/legislative responses: forbid certain transactions for specific taxpayer types; specific blocking rules for manufactured dividends or double-dip credits. ### Tax treatment of complex transactions: repos, securities lending, derivatives - Securities lending: - Typical legislative approach: ignore transfer/return of securities for lender when conditions met; lender taxable on fee income; manufactured payments treated as dividend/interest for lender; borrower tax cost set at market value at time borrowed. - Repo transactions: - Recommended tax treatment: - Disregard both transfer and return of securities for the seller. - Treat excess repurchase price over initial sale as deductible finance charge for seller and includible interest for buyer. - Clarify treatment of manufactured payments. - Avoid transaction taxes on repos/securities lending to support market development. - Derivatives: - Tax models: trend toward mark-to-market (MTM) alignment with IFRS for financial institutions; elective hedging exceptions may apply. - Domestic tax law must accommodate differing legal effects of CSAs under foreign law (absolute transfer of title under English law vs. security interest under NY law). ### Legislative guidance: sample repo provisions and applicability conditions - Sample repo legislative conditions: - Written industry-standard documents; repurchase within twelve months; arm’s length parties; transferee must make manufactured payment if record date occurs during arrangement. - Tax treatment where conditions met: - Ignore sale and repurchase for transferor; treat manufactured payment as dividend/interest for transferor; tax cost and repurchase price equal to market value at initial sale; excess repurchase price treated as deductible finance charge to transferor and includible in transferee gross income. ### Conclusions and policy checklist - Strategic importance: - Efficient LCBM supports capital market deepening, macroeconomic performance, financial stability, and ability to absorb capital flow volatility. - Key legal and operational recommendations: - Government/issuer-level: explicitly authorize borrowing; provide fiscal agency arrangements; transparent public debt management and reporting. - Legal framework: settlement finality, financial collateral protections (ownership rights, close-out netting, substitution), dematerialization via securities holding legislation, investor protections (segregation, prohibition on misuse), clear contractual frameworks governed by issuer law. - Tax law: supply-side clarity on returns and secondary transactions; demand-side alignment across institutional investors; clear, effective tax treatment for non-residents consistent with international practices (e.g., withholding and gains exemptions for government LCBs). ### Annex I — Case study: Georgia (IMF TA and outcomes) - IMF TA support in Georgia focused on: (i) improved contractual framework for government debt securities; (ii) master securities lending agreement; (iii) MoF–NBG fiscal agency agreement; (iv) PDs legal framework; and (v) tax law framework for private equity and insurance. - Capital Markets Plan: released April 2016 by interagency group; identified legal/regulatory and tax impediments. - Tax law reform sequencing: - Supply-side reforms to tax treatment of LCBs (primary and secondary markets) followed by demand-side reforms (investment funds, pension funds, insurance). - Enacted tax law reforms summary: - Package 1 (Rates and concessions): government LCBs exempt from income and capital gains tax for non-resident investors; extended to qualifying corporate bonds meeting stricter eligibility criteria. - Package 2 (Technical amendments): addressed secondary sales (split of capital vs interest), taxation of repos, securities lending, financial collateral, and mark-to-market taxation of derivatives. - Investment funds regime: - Designed to be tax-neutral for investors, familiar legal structures, flexibility for different investors, no local taxation of conduit foreign income, and maximize certainty and simplicity. - Parliament passed amendments to the Tax Code and Law on Investment Funds in July 2020; amendments entered into force on October 19, 2020. - NBG and MoF expected to promulgate joint regulation on opening/maintenance of investor accounts for unit-holders. - Outcomes to date: - Clear tax rules for returns on LCBs and secondary transactions for domestic and foreign investors. - Interest withholding tax and capital gains concessions/exemptions implemented for publicly issued bonds; supported links with Clearstream. - Expectation that full market deepening benefits will take time to materialize after legal and tax reforms. *Source: wpiea2020258-print-pdf* ### 1. IMF’s Approach to Capital Account Liberalization and LCBMs .......................................12 ### 1. IMF’s Approach to Capital Account Liberalization and LCBMs ### Purpose and scope of the Working Paper - Seeks to outline a strategically anchored methodology to strengthen the legal and tax foundations for the development of local currency bond markets (LCBMs), to assist authorities in designing a medium-term law reform plan anchored in a broader capital market development strategy. - Emphasizes that sequencing of reforms is “critical and challenging” and that roles of relevant stakeholders (mainly the government and the central bank) must be well-defined. - Focuses primarily on government securities while also covering relevant aspects of corporate bond markets; does not address company law reform or judicial reform needs. - Draws on IMF staff experience and includes a case study in Annex I (Georgia). ### Key analytical framework and building blocks - Notes that the literature on LCBM development defines specific preconditions and six key building blocks for market development. - The six building blocks comprise: (i) Money Market; (ii) Primary Market; (iii) Secondary Market; (iv) Investor Base; (v) Financial Market Infrastructure (FMI); and (vi) the Legal and Regulatory Framework. - Legal and regulatory frameworks, including tax, are one of these six key building blocks and are critical to LCBM development. ### Legal and tax objectives for LCBM development - Legal framework should: - Clarify legal status of dematerialized securities. - Shield investors from insolvency of custodians. - Prohibit and sanction inappropriate behavior by custodians (e.g., misuse of client assets) and intermediaries (e.g., market manipulation and insider trading). - Govern both primary and secondary markets in government securities. - Tax framework should: - Encourage investment and liquidity in bond markets. - Ensure appropriate tax treatment of repurchase transactions. - Support development of both primary and secondary markets. - Provide clear and effective tax treatment for each key class of investor, including foreign investors, and conform to international good practices. - Tax treatment often becomes essential to establishing links between LCBMs and international FMIs. ### Strategic approach and balance - Law reform plan should be anchored in a broader capital markets development plan; no one-size-fits-all solution. - The LCBM and broader capital market will only develop after an appropriate balance is struck between: - Creating a relatively frictionless legal and tax environment for primary and secondary market transactions; and - Preserving integrity and transparency of the market. - Striking and maintaining this balance upfront will minimize the need for future fundamental policy or regulatory changes that could create market shocks. ### IMF’s legal mandate and role regarding LCBMs - IMF interest in LCBMs is grounded in its legal mandate to promote “exchange stability,” identified among the IMF’s purposes (Article I of the IMF’s Articles of Agreement). - IMF functions, such as surveillance under Article IV, focus on member policies that significantly influence balance of payments and domestic economic stability, which include exchange rate, monetary, fiscal, and financial sector policies. - The size and key features (e.g., currency composition and maturity) of a country’s debt and the mechanisms of financing are important to the IMF. - IMF staff provides general policy advice on debt management and has worked jointly with other IOs under the G20 to support LCBM activity. ### Macroeconomic and financial stability benefits of well-developed LCBMs - A well-developed LCBM can deliver the following potential benefits: - (i) increase of a country’s ability to absorb volatile capital flows and intermediate them efficiently; - (ii) reduction of the reliance on foreign borrowing and of the risks linked to currency mismatch; - (iii) contribution to the reduction of current account imbalances; - (iv) mitigation of the need for large precautionary reserve holdings; - (v) improvement of the capacity of macroeconomic policies to respond to shocks (G20 Cannes Summit, 2011). - LCBMs facilitate development of broader capital markets and create longer term savings products. ### Financial stability implications and the banking sector - Banking sector relies heavily on a well-developed LCB secondary market to manage liquidity via repurchase and securities lending arrangements. - Absence of well-developed LCBM (and eligible collateral) impedes banking sector stability by affecting banks’ ability to manage liquidity and can create risks for central banks’ balance sheets when they accept less desirable collateral for emergency liquidity assistance. - Many public debt laws mandate governments to borrow for both fiscal purposes and financial market development purposes. ### Interaction with IMF Articles on payments and capital movements - IMF purpose to assist in the establishment of a multilateral system of payments and in the elimination of foreign exchange restrictions (Article I (iv) and Article VIII Sections 2 and 3). - Under Article VIII, Sections 2 and 3, members are prohibited, without IMF prior approval, from imposing restrictions on payments and transfers for current international transactions. - Members may impose capital controls consistent with Articles IV, Sections 1 and 3, and VIII, Sections 2(a) and 3, and under Article VI, Section 3 members may exercise controls necessary to regulate international capital movements provided they do not restrict payments for current international transactions. - Article XXX(d) of the IMF’s Articles defines “payments for current transactions” to include “payments due as interest on loans” and “payments of moderate amount for amortization of loans,” so while bond acquisition by non-residents is a capital account transaction, coupon payments and moderate amortization repayments may be treated as current transactions covered by the IMF’s Articles. - The treatment of current account restrictions and their removal affects foreign investor participation in LCBMs, particularly the “exit” via transfer abroad of coupon payments and proceeds from repayment of moderate amounts of amortization repayments. *Source: Local Currency Bond Markets Law Reform: A Methodology for Emerging Markets and Developing Economies (Working Paper), sections I–II.* ### 13. Beyond the current account, the IMF also advises more broadly on capital ### 13. Beyond the current account, the IMF also advises more broadly on capital account liberalization, which is equally relevant. ### IMF institutional view on capital account liberalization and LCBMs - Since 2012, the IMF has an “institutional view” on liberalization and management of cross-border capital flows; this view includes specific reflections on LCBM. - Well-designed capital flow liberalization can help countries realize the benefits of capital flows, forgo the costs of “capital flow measures,” and support key economic objectives (IMF, 2012). - Benefits of liberalization are largest when countries have achieved certain levels of financial and institutional development. - Financial systems need to mediate flows safely, allow firms to access capital to finance productive investment, and give households and firms the ability to diversify portfolios while managing risks. - Institutions need to bolster the resilience of financial, corporate, and household balance sheets. - Liberalization is more likely to be successful if supported by sound fiscal, monetary, and exchange rate policies; exchange rate flexibility can cushion the real economy against capital flow volatility; greater trade openness can support liberalization. - Risks of liberalization are magnified when countries lack sufficient financial and institutional development: - Heightened macroeconomic volatility and vulnerability to crises. - Inadequate financial regulation and supervision can create incentives for financial institutions to take excessive risks, producing more volatile flows prone to sudden reversal. - There is no presumption that full liberalization is appropriate for all countries at all times; the appropriate degree depends on specific circumstances, notably financial and institutional development. - A range of policies is needed to reap benefits while managing risks: - Strengthen and deepen financial markets. - Improve institutional capacity. - Facilitate macroeconomic adjustments (including real exchange rate) to capital flows. - Recognize that policies of source countries (push factors) matter as well as domestic (pull) factors. - Capital outflows that are large, sustained, or sudden can pose significant policy challenges: - Outflows should usually be handled primarily with macroeconomic, structural, and financial policies. - In crisis situations, or when a crisis may be imminent, there could be a temporary role for introduction of capital flow measures on outflows; such measures should be part of a broader policy package addressing fundamental causes of the crisis. - On LCBMs specifically: local bond markets that are well developed and integrated can facilitate the raising and intermediation of non-resident investment; sound regulation and oversight of LCBMs, ideally combined with steps to deepen the markets, ought to be a precondition for opening up to foreign investors. ### Sequencing of capital market development (stages) - Capital markets in emerging markets and developing economies typically develop sequentially in broadly the following order: - Stage 1 — FX - Organization of basic core of FX market. - Based upon well-sequenced opening of current and capital account (see Box 1). - With due regard for pre-conditions. - Stage 2 — Debt Securities - Fixed income securities, including corporate bonds and sovereign debt. - G20 focus on development of local currency bond markets. - Many markets offer basic fixed income securities (typically denominated in local currency), including government bonds (and bills) or LCBs and central bank bills. - With supportive legal settings, secondary sales of debt securities and OTC secondary markets may increase. - This Working Paper focuses specifically on LCBs as a subset of these debt securities. - Stage 3 — Secondary transactions over debt securities - Outright sale, derivatives, securities lending, repos (critical for hedging and liquidity). - Initially related to debt securities. - Repo transactions over government debt securities often common, even in less developed markets. - FX and interest rate derivatives, financial collateral, securities lending and repurchase (or repo) transactions could develop over the short to medium term and are expected to be initially related to debt securities. - Stage 4 — Equity securities - Initial focus on common stock/ordinary shares (often first established earlier). - This market develops over the medium to long term. - Development of related derivative products: Options; Securities lending; Convertible bonds; Hybrid securities and preferred shares. - Equity securities are beyond the scope of this Working Paper, though many legal and tax foundations applicable to LCBs also apply to equity market development. ### Pyramid framework for sequencing law reforms - The legal and regulatory frameworks should be sequenced and can be conceptualized as a pyramid with three layers: - Base layer — Building blocks for the legal foundation of the capital market: - Enforceability of contracts (e.g., enforcing monetary obligations incorporated in bonds). - Property (e.g., enforceability of rights over property against third parties). - Insolvency (e.g., settling competing claims when debtor’s liabilities exceed assets). - Company law (e.g., allowing capital contributions in the form of equity stakes). - Quality of the judiciary is critical; this layer manifests the “rule of law.” - Middle layer — Legal instruments relating to issuance, holding, exchange, exercise, reporting and taxation of financial assets: - Financial audit and reporting; tax law frameworks. - Market access (e.g., exchange controls, pension funds, insurance). - Financial market infrastructure (e.g., settlement finality, custody, dematerialized securities holding, collateral). - Monetary policy (e.g., which securities can be monetized for central bank liquidity). - Banking, insurance and pension fund regulation (e.g., which securities can be held by banks and capital treatment). - Top layer — Legal framework for regulated securities markets: - Organic framework of the securities regulator. - Conditions for access to regulated primary securities markets. - Business conduct rules for secondary market transactions. - Continuous obligations for issuers in regulated markets. - Key principles: - Each legal component plays a critical role; for higher layers to work, underlying layers must function effectively. - International best practice for the top layer may remain aspirational in many developing markets; focus first on basic and middle layers. - Law reform should create a relatively frictionless legal and tax environment for primary and secondary market transactions (including foreign-to-foreign transactions over LCBs) while preserving market integrity and transparency. - In LCB contexts, rule of law and market operational integrity (e.g., objective construction of interest rates, confidence that debt will not be “inflated away”) are essential. - Many legal building blocks in the second layer (e.g., settlement finality, tax rules) apply across stages 2–4, so sequencing of law reforms will not fully map one-to-one to market development stages. - Primary and secondary markets for non-governmental securities involve different stakeholders and may require clearer allocation of regulatory, operational and supervisory roles for public and private securities. ### IMF technical assistance (TA) role and scope - The Working Paper draws on IMF TA experience; IMF Legal Department provides TA at member country request on core financial and fiscal legal instruments underpinning LCBMs and capital market development. - Areas of law reform within IMF Legal Department expertise (bolded in the pyramid in source): - (i) tax (all key aspects); - (ii) central banking; - (iii) payments systems and FMIs; - (iv) public debt securities; - (v) insolvency. - Areas excluded from IMF Legal Department expertise: - (i) company law; - (ii) securities market law; - (iii) corporate governance; - (iv) insurance law; - (v) collective investment vehicles; - (vi) pension funds. - IMF can partially cover or guide cross-cutting legal issues and develop guiding principles on connected issues (e.g., authorization of corporate bond issuance, applicability of conduct of business rules to secondary market transactions in public debt securities). - IMF often partners with other TA providers at member country request to ensure comprehensive law reform support and coordination (e.g., coordinating investment funds taxation with investment funds law provided by another TA provider). - Complementarity with other TA providers (multilaterals such as EBRD and ADB) focuses the IMF on its core expertise: tax, public debt securities markets, settlement finality and collateral frameworks, and monetary policy frameworks; such coordination has proven effective in several country contexts (e.g. Georgia). *Source: wpiea2020258-print-pdf* ### 20. As a precondition for substantive law reform, the legal framework should ### 20. As a precondition for substantive law reform, the legal framework should ### Institutional roles in the Local Currency Bond Market (LCBM) - State represented by the MoF - The State is the most important issuer in the LCBM and plays a critical role in determining the structure of the primary and secondary markets (for instance, OTC v. stock exchange) for its local currency debt instruments. - In early development stages, many States rely heavily on the central bank to manage their debt; later they increasingly develop their own capabilities, including through a public debt management office. - Central Bank - Acts as fiscal agent of the State, including payment of principal and coupon and assistance to the State in the primary market. - Major user of LCB through its monetary policy framework; may issue bills (requiring coordination with the MoF to avoid competition). - Operates and/or oversees critical market infrastructures in which LCBM transactions are settled (e.g., payment and securities settlement system). - Market Authority - Promotes fair and transparent financial markets generally. - Typically less involved in government debt securities operation than private issuer markets because public debt issuance is generally exempted from registration requirements. - Market integrity and anti-fraud rules that apply across the capital market should also apply to government debt securities markets. - Central Securities Depositary (CSD) - Plays a critical role in settlement of LCB transactions. - Often operated by the central bank for government bonds; if private-sector operated, it is often supervised by the market authority and the central bank. - Smooth interaction with the central bank payment system is instrumental to minimize risks. ### Authorization to issue debt instruments — legal certainty required - General finding - Legal certainty and clarity on the legal authorization of any entity intending to issue debt securities supports development of a sound LCBM. - Without authorization, legal validity of issuance can be questioned, potentially dampening investor interest and raising concerns regarding rating, eligibility for acquisition, and accounting treatment. - While implicit authorization may sometimes suffice, explicit and clear authorization is advisable for public law issuers; corporations may face company law questions on authorization. - A. The State - Good practice: provide an explicit legislative authorization for the State to issue bonds and bills. - Authorizing legislation can be: - a country’s “public debt law” codifying a comprehensive regime for public debt, or - a more specific legislative instrument, such as a law of public debt securities. - Authorizing legislation typically combines authorization to issue with procedural aspects (which political authority approves issuance) and may include rules on form and other bond aspects. - Consequence of explicit authorization: bonds and other debt securities issued in accordance with the authorizing legislation are valid obligations of the State; debt limit rules should have no impact on legal validity of the bonds (noting there are countries where that is not the case). - Public debt law should include: - longer-term objectives relating to debt management; - requirement to have a debt management strategy to achieve those objectives; - requirement to have an annual evaluation submitted to the Parliament/Congress. - Typical objective language (example): "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]." - Debt management strategy elements to promote domestic market development: - planned borrowings and other debt management activities expressly to promote market development; - build up a yield curve by regular supply of government securities (bills and bonds); - progressive extension of maturities; - consolidation of debt issues into a few liquid market benchmarks. - Money market scope typically covers bills up to one year; some countries issue treasury bills longer than one year, overlapping with usual LCBs. - Strategic trade-off: building liquid benchmark loans increases roll-over risk but can lead to a better-functioning domestic debt market and lower cost in the medium to long run. - Governments may issue debt securities even with fiscal surplus to ensure sufficient securities for secondary market transactions, particularly for the banking sector. - Practical sequencing: often first issue vanilla securities to build investor confidence, then expand to other debt securities; transparency on public debt management (periodic overviews of domestic fiscal data and overall public debt levels) is required and typically needs coordinated involvement of MoF/Treasury and the central bank. - B. Other Public Bodies - Good practice: include explicit authorization to issue bonds and bills in foundational legislation of public bodies (e.g., Law on Municipalities for sub-national governments; organic law or SOE legislation for State-owned enterprises). - C. Corporate Issuers - Corporate issuers should have explicit legal authorization to issue bonds and dematerialized commercial paper. - Many legal systems limit authorization to certain company types (e.g., akin to French société anonyme). - Options to provide authorization: - blanket authorization in company law or civil code; or - general authorization in company law subject to express authorization in by-laws/articles of association or specific resolutions of managing bodies (e.g., board of directors). ### Substance and form of the securities — contractual framework for local currency bonds - Core problem - Many countries lack a specific and well-calibrated contractual framework for local currency government bonds; foreign-currency bonds governed by English or New York law often have elaborate contractual stipulations, unlike many locally issued government bonds. - Lack of clarity on contractual rights undermines attraction of foreign investors and development of domestic financial markets. - Solution emphasis - Design an appropriate contractual framework, centered on General Terms and Conditions (T&Cs) for bonds and bills. - Optionally complement General T&Cs with Specific T&Cs for a specific bond or bill (typically identified by ISIN); Information Memoranda (IM) can be useful for disclosure but may blur information and legal provisions. - Legal design complexities - Interaction with Civil Code provisions on loan agreements in Civil Law countries. - Interaction between contract and administrative law; some systems have “administrative contract law.” - In common law countries, consider common and statutory rules governing loans of moneys. - Essential General T&Cs provisions (most important first) - Choice of law: unequivocally establish that the bonds and bills are governed by the law of the issuing State. - Dispute settlement: establish that local courts have exclusive competence, excluding foreign courts and arbitration tribunals. - Typical clauses for General T&Cs of Local Law Government Bonds (Box 2) - Definitions: e.g., of “issuer,” “bonds,” and “bills” - Scope of Application: e.g., the T&C would cover all local law governed bonds and bills issued by the issuer, but not necessarily non-negotiable debt instruments (such as Schuldschein) and certainly not foreign law-governed bonds - Issuer: would be the State only, and not State-owned enterprises with separate legal personality or sub-national governments (provinces, municipalities) - Types of Securities: coupon bearing bonds and discount bills - Nominal Amount of the bonds and bills - Currency: in principle, only the currency of the issuer - CSD and legal status under securities holding law (dematerialization): what is the legal form of the bonds and bills under applicable law and how are they held? - Payment: how does the issuer pay coupon and principal? Does it stipulate whether an event of default occurs if there were a failure to pay principal, interest, or other amounts (such as any tax gross-up—see below) when due, after the expiration of any applicable grace period? - Day Count and Business Day Convention: actual/360, actual/365 or actual/actual? What happens if a key date (such as payment or maturity date) is not a business day (e.g. paid on next business day, and whether unadjusted for additional interest)? - Early redemption: possible or not? - Notices - Statute of limitation: follow the rule established by statute or impose contractually a specific term? - Severability - Tax: confirm whether payments in respect of the bonds will be made free and clear of withholding or deduction in respect of taxes (which is typically the case, especially for foreign investors). In the event that any payment is made subject to such withholding or deduction, no additional amounts will become payable by the issuer to the investor unless a contractual gross-up clause is agreed to be included in the T&Cs (which should generally be resisted). - Amendments - Governing Law: will be exclusively the law of the issuer, to the exclusion of any foreign law element - Dispute Resolution: will be exclusively the law courts of the issuer, to the exclusion of any foreign court or tribunal, including arbitration. - Less common clauses in local law-governed bonds - Clauses common in foreign-law governed bonds—status of bonds, events of default, negative pledge clauses—are rarer in local law-governed government debt securities. - Collective action clauses (CACs) are also less common in local law-governed bonds (see Box 3). ### Collective Action Clauses (CACs) in local law-governed bonds (Box 3) - Consideration - CACs permit key financial terms of a bond to be modified upon receipt of support of a qualified majority of bondholders holding a requisite percentage of the outstanding principal. - IMF position and practice - In 2014, the IMF endorsed key features of enhanced CACs only for international bonds. - Inclusion of CACs in local law-governed bonds may make unnecessary retroactive statutory majority voting mechanisms; IMF has not endorsed statutory retroactive modification but such approaches were used in Greece (2012) and Barbados (2017) (see IMF 2020). - Use of CACs in local law-governed bonds is limited; mandatory for all euro-area sovereigns’ bonds with maturities of more than one year since January 1, 2013 (see paragraph 3, Article 12 of the ESM Treaty). - If CACs are used, related issues to address include uniformly applicable information covenants and disenfranchisement. ### Tax treatment and certainty for holders of LCBs comprising government debt securities - Importance - Tax certainty is critical, especially for foreign investors. - T&Cs or IMs are often silent on tax considerations despite typical tax concessions/exemptions (e.g., foreign investors not taxed on gains; interest withholding tax exemptions for coupon payments made to foreign holders). - Tax law settings need careful integration with legal modalities of issuance and trading and with requirements of critical FMIs. - Rationale for tax relief for foreign investors (common international practice) - Lack of enforceability where securities are held through chains of offshore custody structures. - Coupon could be calculated to recoup withholding tax at source or become subject to contractual gross-up (which increases government borrowing costs). - Trading/capital gains could be structured to achieve treaty protection by holding through a tax treaty country. - Baseline tax treatment for non-resident investors for LCBs comprising government debt securities (Table 1) - Gains: Exempt (no withholding tax) - Interest: Exempt (no withholding tax) - Policy note - Ultimate tax treatment is a matter of domestic tax policy; countries remain free to tax gains or returns subject to applicable tax treaties. *Source: wpiea2020258-print-pdf - 20. As a precondition for substantive law reform, the legal framework should* ### 36. However, when developing the T&Cs, the legal policy aspects related to tax ### 36. However, when developing the T&Cs, the legal policy aspects related to tax ### Tax-related Terms and Conditions for Local Currency Bonds (LCBs) - Legal policy aspects related to tax continue to be raised during the course of IMF TA and warrant further consideration. - Two baseline legal policy lines that could be considered with respect to LCBs comprising government debt securities: - 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. - Footnote: 29 Provided, in the case of a contractual gross-up, that this forms part of the terms and conditions of the LCB in question. Box 4. Illustrative Tax Related T&C Provisions - Australian Treasury Bonds have the following provisions: - 3.1. FEES - Coupon Interest Payments and repayment of Face Value at maturity will be made free of any fees, charges, deductions or levies of the Australian Government, except to the extent required by law [with a separate section in the IM confirming the tax treatment, including the applicability of relevant withholding tax concessions/exemptions apply]. - ... - 3.3.3. NO ADDITIONAL AMOUNTS PAYABLE - For the avoidance of doubt, in the event that any payment made by the Commonwealth in respect of Treasury Bonds is made subject to deduction or withholding for or on account of any Taxes, duties, assessments or governmental charges of any nature, no additional amounts shall be payable by the Commonwealth in respect of such deduction or withholding. - ____________________ - Source: https://www.aofm.gov.au/securities/treasury-bonds ### Procedural Aspects of Establishing General T&Cs - Important legal question: 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 drafting and legal policy choices. - Constitutional requirements in some jurisdictions (for instance, Ghana) require Parliament/Congress to approve such General T&Cs, which could affect the timing of debt issuance and management operations. - Good practice also includes consultation 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), the latter could be included in the consultation. ### The Form: Dematerialized Securities Holding Legislation - General acceptance: smooth settlement of bond transactions is best served by issuing and circulating bonds in “dematerialized” form.30 - Two dematerialization approaches: - (i) partial dematerialization, where securities that originally exist in materialized (i.e. bearer or registered) form are “immobilized”;31 - (ii) full dematerialization, where securities have no longer any material form.32 - Result: securities will exist as dematerialized credit balances on securities accounts, held in the books of the CSD or properly licensed custodians, enabling settlement by debits and credits under a “delivery versus payment” mechanism. - Risks: dematerialized securities are held in an “intermediated manner,” through a custodian, which gives rise to other risks that must be mitigated. - Observations on legal frameworks: - Many countries lack robust legal frameworks for dematerialized securities. - Traditional securities law recognizes three forms: (i) bearer securities; (2) registered or “nominative” securities; and (iii) “to order” securities.33 - Core legal questions arise: legal nature of depositors’ claims vis-à-vis depositary; treatment in case of depositary insolvency; exercise of contractual/company law rights vis-à-vis issuer; applicable private international law rules (lex rei sitae issues).34 - Legislative approaches and examples: - Leading jurisdictions have enacted specific “securities holding legislation” for dematerialized securities. - Phased approaches: allowing fungibility of bearer securities (first phase) then full dematerialization (next phase). - Historical example: Belgian Royal Decree Nr. 62 enabling Euroclear International CSD; influenced Luxembourg (Law of 1 August 2001 on the Circulation of Securities) and Art. 8 of the US Uniform Commercial Code.35 - Example of regulatory instrument: Regulation (EU) N° 909/2014 of 23 July 2014 on improving securities settlement in the EU and on CSDs. - Well-designed securities holding legislation should: - require those securities be issued in the competent CSD;36 - determine which types of financial institutions can act as direct participants in those CSDs; - provide clear mechanisms that protect depositors against the insolvency of their custodian; - establish clear rules governing “corporate actions”; - modernize relevant private international law rules. - International instruments to consider: - Geneva Securities Convention of UNIDROIT provides substantive rules on intermediated securities holding.37 - Hague Securities Convention establishes a framework for private international law questions pertaining to dematerialized securities.38 - Practical considerations from IMF TA: - Designing an appropriate securities holding legal framework is challenging; main challenge is fitting rules into the broader legal framework of the country. - Civil law jurisdictions may adapt Civil Code and commercial law with minor tweaks; transplants from other legal traditions (e.g., trust or nominee structures from common law) could cause significant challenges. - Regulatory and supervisory complements: - Legally robust private law framework must be complemented by robust public law regulatory framework. - Regulatory framework should: - establish custodial services to the public as a regulated activity, reserved to properly licensed financial institutions (in most countries, banks and brokers); - require a “fit for purpose” securities holding accounting framework; - require segregation at the higher level (typically the CSD) of custodians’ own holdings from the collective holdings of their clients; - prohibit custodians from using securities deposited by clients without explicit consent; - ensure a strong supervisory framework to enforce these rules as the keystone to investor confidence. ### The Use: Secondary Market and Collateral Transactions A. Outright Sales/Purchases - Outright sale/purchase of bonds or bills in the secondary market raises few legal issues in most jurisdictions. - Such transactions are typically governed by civil/commercial law and the rules of the relevant securities settlement system (or CSD). - When settled “delivery versus payment” in the relevant securities settlement system, delivery and payment occur concomitantly, reducing legal and credit risks. B. Financial Collateral Law - The use of LCBs as collateral is central to the money, FX and interest rate derivatives markets and the broader LCBM. - Local currency government bonds constitute typical collateral in repurchase and derivative transactions under global (e.g. ISDA) or local standardized master agreements. - Main legal problems in many countries:39 - Numerus Clausus Principle and Recharacterization Risk: - Most legal systems fix rights in rem that can be created (numerus clausus), limiting contractual expansion. - Insolvency courts may “recharacterize” non-recognized rights in rem into existing rights, potentially invalidating them. This risk is acute for ownership rights used as collateral (repurchase agreements and transfer of title arrangements under derivative agreements). - Claw Back Rules: - Many jurisdictions have “claw back” or avoidance rules allowing insolvency practitioners/courts to return payments and asset transfers made by an insolvent party prior to 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 substitution and margin calls: substitution allows contractual substitution of one security with another during the collateral contract; margin calls allow the collateral taker to request additional securities after marking to market if collateral falls below a threshold. Isolated deliveries during the suspect period could be declared unenforceable. - Risks to Close-Out Netting: - Insolvency laws often render set-off and netting unenforceable against the insolvent estate after an insolvency event. - Opening an insolvency procedure typically triggers a statutory moratorium on creditor action without court permission. - This undermines close-out netting provisions that allow one party to terminate outstanding transactions, calculate exposures, net mutual exposures, and enforce financial collateral to satisfy net claims. - To mitigate these legal risks, most countries need to adopt “financial collateral” legislation that may be combined with settlement finality legislation and/or derivatives recognition amendments. - Substantive objectives of such legislation: - Explicit recognition of the legal validity and enforceability of repurchase and other transfer of title arrangements by way of security, removing recharacterization risk; - Protection of collateral substitution and margin call during suspect periods (except for explicit fraud); - Modernization of pledge rules, especially for cash collateral and dematerialized securities, allowing enforcement without court order and 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; - Modernization of private international law principles for collateralization of dematerialized securities. - International standards and good practice: - UNIDROIT’s Geneva Securities Convention and “Close Out Netting Principles” provide benchmarking for law reform. - The Hague Securities Convention and the EU Financial Collateral Directive are cited as examples of good practice. C. Central Bank Monetary Policy Legal Framework - The legal framework governing the central bank’s monetary policy implementation regulates how the central bank enters into Lombard and other “open market” operations, and other financial transactions, to influence monetary conditions and pursue price stability. - Legal nature: generally dual — - general principles established in the central bank law; - detailed rules laid down in contractual legal instruments (“general terms and conditions”), although some countries use a regulatory instrument. *https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020258-print-pdf.pdf* ### 51. The degree to which the monetary policy legal framework will allow ### The degree to which the monetary policy legal framework will allow counterparties to collateralize LCBs with the central bank ### Monetary policy legal framework and collateralization - The ability of counterparties to collateralize LCBs with the central bank strongly affects the attractiveness of those bonds for banks (the typical central bank counterparty). - Government bonds are generally not problematic as collateral because they are the collateral of choice for most if not all central banks. - Corporate bonds differ: acceptance of local currency corporate bonds that meet a certain standard (e.g., a minimum rating) combined with strong risk management measures (e.g., measures addressing lower liquidity) is not inherently irreconcilable with sound risk management and deserves consideration. - Legal frameworks should support wide circulation and broad use of corporate bonds, including as financial collateral. ### Repurchase agreements and market development - Central banks often use bespoke, local law-governed master repurchase agreements rather than internationally accepted master agreements (e.g., the GMRA). - Local law master agreements often become de facto or de jure local market standards, including for pure inter-bank transactions without central bank involvement. - A well-structured and balanced central bank 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. ### Tax treatment objectives for primary and secondary LCBM transactions - Tax laws should encourage investment and liquidity in bond markets by ensuring: - appropriate treatment of repo transactions; - development of both the primary and secondary market; - a clear and effective tax treatment for each key class of investor that conforms to international good practices, including for foreign investors. - The tax treatment of investment in the LCBM is essential to establish critical links between LCBMs and international FMIs. - Guidance focuses on developing an appropriate legal framework for taxation of LCBs comprising government debt securities, noting some aspects apply across debt and equity securities. 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. ### Multi-step approach to tax law reform of LCBMs - Many countries have inadequate tax law frameworks governing LCBs, creating material tax impediments to primary and secondary LCBMs. - Recommended multi-step approach: - Undertake a comprehensive diagnostic review of the existing tax law framework covering substantive and administrative provisions. - (a) Identify existing impediments and gaps relative to international good practices. - (b) Develop law reform options to address those impediments and gaps. - Tax law framework should provide certainty for all key primary and secondary market transactions for all key investor classes. - Tax law reform plans should be developed systematically and coordinated with national capital market development plans; legislative action depends on each country’s legal tradition and baseline tax law framework. ### Supply-side tax treatment—scope and issues to address - First step: address each key investor class from a supply side perspective (treatment of the LCBs themselves). 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). - Key supply-side objective: remove tax biases by achieving tax neutrality between LCBs and alternative financial instruments. - Example: a gain on secondary sale treated at ordinary income tax rate (e.g. 30%) rather than reduced interest rate (e.g. 15%) when attributable solely to accrued interest would adversely affect liquidity and secondary market activity. ### Legal modalities and treatment of foreign investors - Tax alignment must consider legal modalities relating to issuance, trading of LCBs, and associated FMIs. - Facilitating foreign investment often requires interest withholding tax and capital gains/profits tax concessions/exemptions for returns and gains on LCBs consistent with international common practice to achieve links with international FMIs. - More generous tax treatment often applies to non-residents investing in LCBs to attract FMIs; ultimate tax treatment remains a matter of domestic tax policy. - Baseline tax treatment for LCBs comprising government debt securities (Table 2) as presented: - Investors | Gains | Interest - Residents | Tax* | Tax* - Non-residents | Exempt** (no withholding tax) | Exempt** (no withholding tax) - If taxing investors on LCB gains or returns, tax treatment should be clear and unambiguous under tax law; uncertainty deters foreign investors. - Certainty requires clarity on: - characterization as revenue gain or capital gain; - tax timing of the gain; and - whether the gain has a local source. - In practice, many jurisdictions do not tax foreign investors on their LCB gains due to complexity and enforcement challenges; legislative confirmation is often needed to preserve exemptions when local intermediaries are used. ### Defining "interest" and related tax neutrality issues - “Interest” should be defined broadly in tax law to capture ordinary coupons and amounts functionally equivalent to interest (e.g., time value payments under swaps, payment of defaulted interest by a guarantor). - Align tax treatment of income from Islamic financial transactions (sukuk) with economically equivalent conventional transactions. - Capturing amounts functionally equivalent to interest improves neutrality between similar instruments. ### Treatment of accrued interest and secondary sales - When a debt security is sold between interest payment dates, part of the sale price typically represents accrued interest. - Common issue: tax law does not differentiate gains on sale from accrued interest; misalignment can create incentives to time transactions or apportion coupon amounts to avoid adverse tax outcomes. - Common international practice in major financial centers: treat the portion of sales price representing accrued interest as interest. - Under this treatment, the seller reports part of the sales price as interest income, and the buyer treats the interest amount subsequently received as a return of capital, reducing their tax basis. ### Need for comprehensive, comparable rules for complex transactions - As markets mature, more complex bond offerings and secondary market transactions arise (discounts, premiums, maturity amounts, repos, securities lending, financial collateral, derivatives). - Tax law frameworks should provide clear, internationally comparable rules for determining tax treatment of all returns from LCBs and typical secondary market transactions entered into by each key class of domestic and foreign investor to support liquidity, hedging, and market-making. *Source: wpiea2020258-print-pdf - 51. ### 65. The tax law framework should also embody appropriate rules-based integrity ### 65. The tax law framework should also embody appropriate rules-based integrity ### Rules-based integrity provisions to combat abusive tax structures - Necessary to combat: - Bond washing: selling a bond just before it pays a coupon and buying it back once the coupon has been paid to realize a tax-free capital gain or avoid withholding tax on the coupon. - Inappropriate deferral of tax under deeply discounted securities by taxing them on an accruals basis. - Secondary market transactions (e.g., repos and securities lending) can create unacceptable tax avoidance opportunities, including from interactions or gaps between tax rules. - Responses include: - Forbidding certain transactions for specific taxpayer types (example: N-accounts in the Belgian X/N clearing and settlement system). - Specific legislative rules to eliminate opportunities (example: eliminating potential double dip of tax credits through manufactured dividends). ### Market development and the case for comprehensive upfront tax rules - An advisory, placement and asset management industry typically develops around LCBs; complexity of LCBs and availability of other financial products increase over time. - A comprehensive tax law framework upfront: - Ensures preparedness for sophisticated transactions as markets deepen. - Provides certainty on tax characterization (e.g., whether indexed component is interest income rather than capital gain). - Provides certainty on tax timing (e.g., whether accruals taxation could apply, particularly where LCBs are capital-indexed). - Complexity or uncertainty of tax treatment can materially and adversely impact investor appetite. - Complex and highly structured bonds can, in substance, resemble equity (example: convertible features adopted for solvency reasons). - Many domestic tax systems have rules to determine whether an instrument constitutes debt or equity for tax purposes. ### Adequacy of tax law framework for secondary market transactions - Focus areas for ensuring adequate tax law framework: - Derivatives - Securities lending - Repos ### Derivatives: characteristics and tax-treatment options - Derivative types: forward contracts, futures, swaps, options and combinations. - Typical documentation: ISDA Master Agreement, Schedule, and Credit Support Annex (CSA) — collectively referred to as the ISDA. - CSA role: one counterparty typically required to provide cash or securities as financial collateral in respect of mark-to-market (MTM) exposure. - Choice of law for ISDA documents: - Parties often use documents governed by foreign law (e.g., NY Law CSA or English Law CSA). - English Law CSAs typically give rise to an absolute transfer of title of collateral. - NY Law CSAs generally give rise to security interests only (similar to pledge). - Domestic tax law needs specific rules to accommodate both possibilities to achieve neutrality. - Where absolute transfer of title occurs, arrangement operates similarly to securities lending and related rules (e.g., disregarding both the transfer and return of financial collateral for the collateral giver) become important. - Where mere security interest arises, tax law commonly does not treat the transfer as a disposal (analogous to a mortgage situation). - Tax models for derivatives: - Trend toward aligning tax treatment of derivatives with accounting treatment under IFRS, particularly for financial institutions. - Under MTM-aligned tax model, positive movements in the value of a derivative contract (fair value or MTM movements) would be subject to tax each year, even if unrealized. - Mention of recent derivatives reforms in the U.K. and proposed reforms in the U.S. - Elective exceptions to MTM taxation: - Hedging exceptions may disregard fair value/MTM movements on the derivative and instead align tax accounting with the hedged item. - Realization basis where MTM does not apply: - Derivative transactions taxed on realization basis: gains/losses brought to account when periodic and final balancing payments are payable/made. - Authorities should be vigilant for signs of abuse given flexibility in settlement and potential arbitrariness of tax consequences. ### Securities lending arrangements and financial collateral: features and tax consequences - Essential features of a securities lending agreement (SLA): - Lender transfers securities to borrower in return for promise to return unascertained identical securities, either on a fixed future day or on demand (commonly with maximum term of less than 12 months). - Transactions typically affected under the Global Master Securities Lending Agreement (GMSLA) or, for financial collateral in derivatives, a CSA. - As in a repo, all transfers of securities pass absolute title to transferee (i.e., no “loan” of securities). - Borrower typically pays a fee to lender, calculated or earned similarly to interest. - Security is usually provided by borrower in one of three ways: - Irrevocable standby letter of credit or guarantee from a creditworthy institution; - Cash collateral; - Non-cash collateral (e.g., equities or debt securities such as LCBs) under a parallel securities loan where absolute title to collateral passes to the lender. - If a record date for dividend, coupon or other distribution occurs during borrowing period, borrower must typically make a manufactured payment to the lender equal to the distribution. - Tax consequences in absence of specific provisions: - Lender treated as having disposed of securities at the time the SLA was entered into, potentially realizing a taxable gain or loss based on market value at that time. - Typical legislative approach to securities lending arrangements: - Treat lender as though it never disposed of the securities when lent; lender taxable on fee income. - Ignore gains/losses that would otherwise be realized by the lender on transfer and later acquisition of equivalent securities. - Return of equivalent securities does not itself result in gain or loss to borrower; borrower’s overall profit/loss depends on value differences when selling/returning securities. - Borrower includes dividend, coupon or distribution in gross income but may deduct manufactured payment payable to lender, achieving tax neutrality. - Manufactured payment included in gross income of lender and may be treated as dividend or interest as appropriate. - Sample legislative provisions (summary of conditions and effects): - Conditions for application include: written industry-standard documents; return of security (or equivalent) within twelve months; arm’s length parties; borrower required to make manufactured payment if record date falls during arrangement. - Effects when conditions met: - Delivery and return of securities ignored for lender. - Manufactured payment treated as dividend or interest on the securities for the lender. - Tax cost for borrower and consideration for return treated as equal to market value at time borrowed. - Borrower must include gains and may deduct losses related to the arrangement in gross income. ### Repo transactions: features and tax-treatment guidance - Essential repo features: - One party (Seller) sells unascertained securities to Buyer for a fixed cash price (equal to approximately the current market value of the securities or between 100% and 105% thereof), with immediate settlement (spot sale). - Simultaneously, Buyer agrees to sell to Seller unascertained identical securities on a fixed future date or on demand for cash (forward sale). - Re-purchase price is a function of spot sale price; illustrative calculation: - If market rate for a cash deposit is 6% pa, repurchase price = initial purchase price × 106% × number of days between completion dates ÷ 365 (or sometimes 360). - Buyer effectively receives initial purchase price plus an amount equivalent in substance to interest. - All transfers of securities pass absolute title to transferee. - If repo straddles a record date for interest or other distribution, Buyer must pay equal amount to Seller on the income payment date; variation where repurchase price is reduced instead is a “buy/sell” rather than a “repo”. - Principal difference from securities lending relates to character of cash passing at time securities are “lent”: - Securities lending: cash collateral is a security deposit to facilitate set-off or netting on default. - Repo: cash is the purchase price; initial Seller does not need set-off or netting ability to retain cash on Buyer default/insolvency. - Tax policy recommendations for repos (Box 8 key considerations): - Disregard both transfer and return of securities for the seller to avoid taxable gains/losses being realized by the seller. - Treat as interest (or equivalent) the amount by which agreed repurchase price exceeds initial sale amount to align tax with economic substance. - Ensure taxation of third-party transactions (e.g., rehypothecation or reuse) for the buyer. - Clarify tax treatment of manufactured payments; they could be treated as equivalent to receipt and payment of interest on the securities. - Avoid transaction taxes on repos or securities lending transactions as they are not helpful in developing capital markets. *Italic source attribution: wpiea2020258-print-pdf - 65. The tax law framework should also embody appropriate rules-based integrity* ### 82. A sample set of legislative provisions are set out in Box 9 below (which largely ### wpiea2020258-print-pdf - 82. A sample set of legislative provisions are set out in Box 9 below (which largely ### Repo Arrangements (Box 9: Sample Legislative Provisions: Repo Arrangements) - Applicability: - (1) Subsection (2) applies when a repurchase (repo) arrangement is entered into that satisfies the following conditions: - (a) the arrangement has been entered into in writing using industry standard documents; - (b) the security (or an equivalent security) is repurchased within twelve months after it is transferred; - (c) the parties deal at arm’s length in relation to the transaction; - (d) if a record date for the payment of a dividend, coupon or other distribution occurs during the period of the arrangement, the transferee is required to must make a manufactured payment to the transferor of the relevant securities equal to the amount of the relevant distribution. - Treatment where subsection applies: - (2) Where this subsection applies, the arrangement is to be treated as follows: - (a) both the sale of the securities and the repurchase of securities or equivalent securities from the transferee are ignored for the transferor; - (b) this Act applies to the transferor as if the manufactured payment under the arrangement were a dividend or interest on the securities (as the case may require); - (c) the tax cost of the acquired securities for the transferee and the repurchase price for the securities or equivalent securities by the transferor is to be treated as being equal to the market value of the securities at the time that they were initially sold by the transferor to the transferee; - (d) the amount by which the agreed repurchase price exceeds amount received on the initial sale of the securities is to be treated as a deductible finance charge to the transferor and is to be included in the gross income of the transferee; and - (e) the transferee must include any other gain related to the arrangement in gross income and may deduct any loss related to the arrangement from gross income in accordance with the Act. ### Demand-side treatment (Sections 83–85, Box 10) - Objective: - Align tax treatment of LCBs between key institutional investor groups (including mutual and investment funds) to encourage investment and liquidity in LCBMs; focus is on making financial investments more attractive to investors and understanding effective tax treatment across investment channels. - Scope and limitations: - Detailed tax law design for each investor class is beyond the Working Paper’s scope and requires country-specific analysis of tax settings and capital markets development plans (e.g., pension fund regimes). - Example: an Exempt/Exempt/Taxed (EET) pension fund system typically operates as a deferral system and can incentivize investment in LCBs relative to ordinary bank savings which commonly operate under a Taxed/Taxed/Exempt (TTE) system. - Key investor classes and tax law issues to address (Box 10): - Investment and mutual funds: - tax rules should be attractive and neutral to investors (channel savings into investment; not put investors in a worse situation than if they had invested directly); - consider treatment of investment management activity to encourage local management of funds. - Pension funds: - Exempt/Exempt/Taxed (EET) system or otherwise; - include national pension schemes and significant internal/private firm schemes and their tax treatment to address market inefficiencies. - Insurance companies (life and general): - assess relative tax treatment/neutrality of long-term savings through life insurance policies versus other investment options. - Other investors: - local financial institutions and foreign investors (e.g., SOEs, family offices). ### The Post Trading: Settlement Finality Law (Sections 86–90, Box 11) - Post-trading infrastructure components: - central bank’s real time gross settlement system (settles cash leg of bond transactions); - securities settlement system of the central securities depository (settles securities leg); - delivery versus payment is ideal to reduce credit risk; clearing houses and CCPs centralize transactions and enable netting. - Main insolvency-related legal risks to post-trading infrastructures: - Zero-Hour Rule: insolvency law rule invalidating payments and asset transfers after 0.00 h. on the insolvency declaration day. - Claw-Back Rules: reversal/invalidation of certain payments and securities transfers executed before insolvency opening. - Non-Enforceability of Netting: could cause non-enforceability of clearing, payment and settlement executed on a net basis. - Consequences: - Payments and securities transfers executed after systems open (example: between 9.00 h. and 15.00 h. if insolvency declared at 15.00 h.) may be invalidated, causing returns to the insolvent estate and spillover/ripple effects. - Purpose and main components of Settlement Finality Legislation (SFL) (Box 11): - Ensure payments and securities transfers effected up to the (notification of the) opening of insolvency are definitive (“final”). - Personal scope of application: - define which systems and which financial institutions (e.g., banks, securities firms) receive finality protection; linkage to direct access rights to post-trading infrastructure. - Timing and information mechanisms: - protect payments/settlements effected before the operator of the system is formally notified of a participant’s insolvency; requires formal court notification to the operator. - Override of “zero-hour” rule: - SFL overrides zero-hour rule for covered financial institutions and recognized post-trading infrastructures. - Validity and enforceability of netting: - SFL declares netting and set-off between covered financial institutions in recognized infrastructures. - Override of “claw-back” rules: - SFL overrides claw-back rules for covered participants and recognized infrastructures (with some SFLs allowing claw-back enforcement outside infrastructures). - Operational notes: - IMF staff provides TA on SFL design; design is complex and requires understanding of insolvency law and concursus creditorum; IMF conducts training and focused discussions with member country authorities. ### Fiscal Agency Agreement (Sections 91–95) - Role and importance: - Fiscal Agency Agreements establish central bank roles as “banker to the State,” including depositary functions for State financial assets, making payments on the State’s behalf, and roles in issuance and management of public debt instruments. - Legal and operational form: - Key features often in central bank law or public debt legislation, but an agreement (formal contract or exchange of letters) is typically required to specify roles; governed by a mix of contractual and administrative law principles. - Core content elements: - Rules for State cash “current accounts” and Treasury Single Account: which accounts are held, debit/credit mechanics, whether credit balances are remunerated, and procedures for payments on coupons and maturing principal of local currency government bonds. - Clear delineation of roles when central bank organizes auctions while the State (through MoF) announces auction calendar and determines cut-off prices. - Transparency: - Clear delineation of roles builds market confidence and argues for publishing the Fiscal Agency Agreement, which many central banks do not publish. ### Conclusions (Sections 96–97) - Strategic importance: - Developing an efficient and effective LCBM supports capital market deepening, macroeconomic performance, and financial stability; enhances ability to respond to shocks and absorb volatile capital flows. - Policy checklist and recommendations: - Government/issuer-level: - Legislation and legal instruments (e.g., fiscal agency agreement) should clearly stipulate the government’s borrowing ability and authorization of entities to operate in these markets; - Provide effective monitoring, reporting, and accountability mechanisms. - Legal framework underpinning LCBMs should: - Provide settlement finality for payment and security transfers, protecting finality from insolvency and related laws; - Protect against legal risks associated with “financial collateral” by ensuring ownership rights over collateral, close-out netting, and operational flexibility (e.g., right of substitution); such protections can be combined with SFL in a single instrument; - Support dematerialization of securities via securities holding legislation recognizing ownership through credit balances in securities accounts (electronic records) rather than physical holding; - Provide investor protections including mandating segregation and safekeeping of assets and prohibiting use of client assets without consent; - Provide regulatory legal basis for primary and secondary markets organization aimed at: (i) maintaining fair, efficient and transparent markets; (ii) reducing systemic risk; and (iii) protecting investors, including powers to prohibit and sanction custodian and intermediary misconduct; - Ensure contractual frameworks for government debt securities (e.g., T&Cs) are robust and exclusively governed by the law of the issuer, to the exclusion of any foreign law element. - Tax law framework: - Supply side: clear and certain rules for tax treatment of returns from LCBs (e.g., interest, discount, maturity amounts, treatment of gains on sale) and secondary market transactions (repos, securities lending, financial collateral, derivatives); - Demand side: align tax treatment across key institutional investor groups (mutual, pension, investment funds) to encourage investment and liquidity. - Non-resident investor treatment: - A clear and effective tax treatment for each key investor class conforming to international good practices is critical, especially for foreign investors; common international practice often applies more generous tax treatment for non-residents investing in LCBs comprising government debt securities (for instance, non-imposition of interest withholding tax, and exemption from tax on gains on those LCBs). *Italic: Source — wpiea2020258-print-pdf (content unit provided).* ### ANNEX I: CASE STUDY—GEORGIA ### ANNEX I: CASE STUDY—GEORGIA ### IMF technical assistance and legal reform work - The IMF’s Legal Department, in coordination with the Monetary and Capital Market Department, provided significant TA support for the development of capital markets in Georgia, including the LCBM. - Ongoing TA activities include development of: - (i) an improved contractual framework for government debt securities; - (ii) a master securities lending agreement; - (iii) a MoF-NBG fiscal agency agreement; - (iv) a PDs legal framework; and - (v) a tax law framework for private equity and the insurance sector. - TA built on prior law reform support, including payment systems law, securities holding legislation and tax law framework for financial instruments and investment funds. - IMF TA emphasized sequencing consistent with the GN: starting with primary market reforms, then secondary market transactions, then demand-side reforms such as investment funds, pension funds, insurance sector. TA was more intensive on secondary market transactions (e.g. secondary sales, repos, securities lending, financial collateral and derivatives) and on investment funds to ensure tax neutrality when investing in securities. ### Policy context and Capital Markets Plan - Increasing access to finance was a key objective of Georgia’s Social-Economic Development Strategy “Georgia 2020”. Inefficient financial intermediation and underdevelopment of capital markets were identified as major impediments.57 - The authorities released the Capital Market Development Strategy and Action Plan (Capital Markets Plan) in April 2016. The Plan was drafted by an interagency group created by the Prime Minister and represented a unified vision of the NBG, MoF, MESD and other stakeholders. - The Capital Markets Plan identified impediments including unsatisfactory legal and regulatory frameworks, particularly taxation. ### Tax law reform focus and sequencing - Authorities prioritized reforming the tax law framework for primary and secondary bond markets. - Reforms proceeded from addressing the “supply side” of LCBs (tax treatment of LCBs in primary and secondary markets) to the “demand side” (alignment of tax treatment across key institutional investor groups, including mutual and investment funds). - Summary of enacted tax law reforms (Box A): - Package 1 (Rates and concessions) - LCBs in the form of government debt securities benefit from tax exemptions on income and capital gains for non-resident investors. This was extended by Package 1 to qualifying corporate bonds that meet stricter eligibility criteria. - Package 2 (Technical amendments) - Technical amendments to remove tax impediments and provide investor certainty, covering: - Secondary sales (split between capital and interest component); - Taxation of repos (consistent with section VIII); - Taxation of securities lending (similar to repos); - Treatment of financial collateral (similar to repos); and - Taxation of derivatives (mark-to-market). ### Investment funds tax regime and related measures - After the tax reforms above, authorities finalized the design of a tax regime for investment funds to deepen capital markets by strengthening the demand side. - The investment fund framework: - (i) uses legal structures familiar to investors and draws on overseas experience; - (ii) achieves tax neutral outcomes for investors (same or better treatment than direct investments); - (iii) provides flexibility to cater for different investors (e.g. tax treaty entitlements); - (iv) ensures no local taxation of conduit foreign income; and - (v) maximizes certainty and simplicity. - Parliament passed amendments to the Tax Code of Georgia (along with the Law of Georgia on Investment Funds) in July 2020 and these amendments entered into force on October 19, 2020.58 - Under the amendments, the NBG and MoF are expected to promulgate a joint regulation governing opening and maintenance of investor accounts for unit-holders in common funds.58 ### Outcomes to date and outlook - Georgia now has a tax law framework that provides clear, internationally comparable rules for determining tax treatment of returns from LCBs (e.g. interest, discount, maturity amounts) for all key classes of domestic and foreign investors (retail and institutional). - Reforms created certainty for tax treatment of secondary market transactions over LCBs (gains on secondary sale for retail and institutional investors; repo, securities lending, financial collateral, and derivative transactions for institutional investors). - Interest withholding tax and capital gains tax concessions/exemptions for publicly issued bonds were implemented to facilitate foreign investment; these measures have supported establishment of investment links between Georgia’s bond market and Clearstream.59 - The tax law framework for investment funds is internationally competitive and aims to attract local and foreign investment into locally domiciled CISs by achieving tax neutral outcomes. - Given that these tax law reforms are new and accompany broader capital market reforms, it is expected to take some time before full benefits (increased investment and liquidity in LCBMs) can be measured. Nonetheless, removing tax impediments has created conducive legislative conditions to deepen Georgian LCBMs. *Source: wpiea2020258-print-pdf - ANNEX I: CASE STUDY—GEORGIA* --- _Source: https://www.imf.org/-/media/files/publications/wp/2020/english/wpiea2020258-print-pdf.pdf_