Derivatives, swaps, credit

derivatives and their tax

implications
Over recent years there has been tremendous growth followed by swift contraction in
the use of financial derivatives by a wide range of corporations and financial institutions.
Despite the clear benefits that the use of derivatives can offer, perception of this
instrument has been damaged by the media coverage of financial disasters where the use of
derivatives has been held responsible. Great losses have been reported by a number of highflying buyers and providers of derivatives.
Although banks have had bigger losses with plain vanilla loans, derivatives have generated
such negative coverage that internal and external supervisory bodies have implemented
stricter control on them.
Derivatives are assets whose values are determined by the value of some other
underlying asset. There are two common types of derivative contracts: those patterned on
forward and those on option. Underneath, these specific types of derivative contracts
(discussed below) are widely exercised in Indonesia with few statutory rules.

FORWARD
In a forward contract one party agrees to deliver a certain commodity on a specified date and
at a specified price. The commodity can be a real commodity such as gold or wheat or a
financial asset such as foreign exchange or shares.

FUTURES
Futures are similar to forwards in all but two aspects. First, futures are traded on organized
commodity exchanges. Forwards, in contrast, are traded over-the-counter only, without
posted prices. Secondly, a forward contract involves only one cashflow, at the maturity of the
contract, while futures contracts generally require interim cashflows before maturity.

OPTIONS
Options are traded both through organized exchanges and over-the-counter. An option is a
contract giving the owner the right, but not the obligation, to purchase (call) or sell (put), at
expiration, an amount of an asset at a specified price.

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SWAPS
Swaps are private agreements between two parties to exchange cashflows in the future
according to a prearranged formula.
There are two commonly known types of swaps: interest rate swaps and currency
swaps.
A plain vanilla interest rate swap is an agreement between two counterparties to
exchange a stream of fixed interest rate payments for a stream of floating interest rate
payments. Both streams are denominated in the same currency and are based on a notional
principal amount. The notional principal is not exchanged.
In its simplest form, currency swaps involve exchanging principal and fixed rate
interest payments on a loan in one currency for principal and fixed rate interest payments on
an approximately equivalent loan in another currency.

CREDIT DERIVATIVES
Credit derivatives are, in essence, traditional derivatives (forwards and options, both on a
stand-alone basis or embedded in the form of structured notes) re-engineered to have a credit
orientation.
The principal products usually referred to as credit derivatives encompass three
instruments:
Total rate of return swaps: These are adaptations of the traditional swap format to
synthetically create loan or credit asset- like investments for investors. Under a total return
swap, one party agrees to pay the other the return on a loan asset in return for a regular
floating rate interest payment based on the underlying loan balance.
Credit spread products: These are generally forwards or options on the credit risk
margins on credit assets. Credit spread products are typically structured as forward rate
agreements or options, which involve a net cash settlement based on the difference between
an agreed spread and the actual spread between two securities.
Credit default products: These are similar in structure to put options on credit assets
and are usually structured as instruments that give an agreed payoff on the occurrence of
specific credit event. Credit default products generally involve one party making regular
payments based on a notional principal amount, in return for the other party making an
agreed default payment if a defined credit event occurs.

INDONESIAN CENTRAL BANK REGULATORY ISSUES

Derivative transactions are mainly governed by Decree of the Directors of Bank Indonesia
No 28/119/KEP/DIR (December 29 1995).
This decree states that banks are only allowed to undertake derivative transactions in
relation to foreign exchanges and interest rates. This then raises the question of whether a
Bank is allowed to enter into or to purchase credit derivative products.

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Under the Banking Law and under banks' natural functions, banks primary activities
are raising funds from the public and channeling them back to the public in the form of
credits. The main assets (and also risks) of banks are therefore, credits. Banks can reasonably
deal with credits directly (for example, by granting credits direct to their counter-parties) or
indirectly (by entering into or by purchasing credit derivatives). It is logical then that Bank
Indonesia never intends to disallow banks from managing their own assets and risks through
credit derivative transactions.
In the further development, Bank Indonesia also issued a limitation on the amount of
certain derivative transactions entered into with non-resident counterparty in the amount of
$3 million or its equivalent, either for each individual transaction or for total outstanding
gross position per bank at one time. This limitation is stipulated in Regulation of Bank
Indonesia No 3/3/PBI/2001 (January 12 2001). The limitation does not apply for hedging
purposes in the framework of investment in Indonesia.
Problems can arise because the regulation does not specify if the limitation stipulated
is also inapplicable for banks if they try to square their positions to a third party (nonresident) if as a result of the investment-related swap/derivative transaction, the banks need
to hedge their position.
Because of the limit on the types of transactions being subjected to the regulation
(that is, those involving foreign currency against Rupiah deals) and considering that the new
regulation is aimed at reducing the fluctuation of the value of Rupiah in order to secure the
stability and integrity of the Indonesian financial system to support continuous economic
growth, the new regulation should not be applicable to credit derivatives.

GENERAL LEGAL PROBLEMS

In Indonesia, there have been a number of swap/derivatives cases filed with the court. There
have been at least 10 cases submitted to the District Court of South Jakarta alone, two cases
submitted to the District Court of Central Jakarta and several bankruptcy cases. Most of these
cases deal with the issue of legality, that is, whether swap/derivative transactions are valid,
binding and enforceable under Indonesian laws. Most of these cases were either resolved
amicably or finally won by the banks in the Supreme Court.
In most litigation cases, the actual legal issue is mainly re-characterization. Can the
swap/derivative transactions be re-characterized as something different from what it purports
to be, and as result will this affect the enforceability of the obligations and enable one party
to escape from its obligations ?
In principle, once the parties concerned have expressed their intention to enter into a
swap/derivative transaction, there should be no room left for recharacterization (except for
tax purposes). The laws should uphold the idea that both parties involved in civil matters are
the ones which really know what they wish. Because corporations are also legally and
economically mature to know and understand what they are doing when entering into the
transaction labeled swap/derivative, any argument of inducement, when it is used by
corporations and when it comes to the anticipated or unanticipated outcome of the transaction
should be seen as an idea from the past. The swap/derivatives cases reaffirm the value of the
approach taken by buyers or providers of swap/derivatives in Indonesia when exercising this
rapid transaction: understand the character of your counterparty and calculate the legal risk
before your gain.

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TAX IMPLICATIONS
There has not been any specific regulation that deals with tax treatments over derivatives,
swaps or credit derivatives in Indonesia. However, this does not mean that the income
received from or in connection with the transactions is not subject to tax. In accordance with
the general principle of Indonesian income tax, any additional economic capability received
or obtained by the tax payer, either from onshore sources or from offshore sources, in
whatever name or form constitutes taxable income pursuant to Law No 7 of 1983 (as
amended, most recently by Law No 17 of 2000).

Tax treatment for forwards

In 1993, the Directorate General of Taxes issued guidance on the tax treatment of currency
forward sales (in the Circular of the Directorate General of Taxes No SE-12/PJ.313/1993 of
May 18 1993). This regulates two different treatments over currency forward sales:
Regular currency forward transactions are described as sales/purchases of foreign
currency, delivery of which is to be performed in the future at a value agreed by seller and
buyer at the time the contract is concluded.
On this regular currency forward transaction, the tax authority restates that the
forward premium paid is a tax object for the recipient and thus is taxable through the selfassessment system. Thus, the premium (together with the overall income of the recipient)
will be subject to the general (individual or corporate) rate prescribed in the Income Tax
Law.
Forward transactions combined with a placement of time deposits denominated in
foreign currency (called camouflage forwards). Camouflage forwards are described as
contracts between the bank customer and the bank where the customer will deposit a number
of foreign currencies with the bank and receive an interest in return and, at the same time, the
customer sells forward the foreign currency against Rupiah at a pre-agreed rate.
For this type of forward, the tax authority considers the premium received as part of
the interest on the deposit. Therefore, in accordance with Government Re gulation No 131 of
2000 (December 15 2000), oil the premium received the following withholding tax rates
apply:
a final tax rate of 20% of the gross amount for residents (except for banks and certain
pension funds) and permanent establishment; or
a final tax rate of 20% of the gross amount or other rate subject to the relevant tax treaty
for nonresidents.

Tax Treatment of swaps

In 1998, the Directorate General of Taxes issued Circular Letter of the Directorate General of
Taxes No SE-03/PJ .43/1998 (February 9 1998) to explain further the tax treatment over
interest on deposit using swap/forward facility. This circular letter determines that the
following swaps premiums are not interests (and thus follow the general tax treatment):

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a swap premium paid for loans in foreign currency reported to and confirmed by Bank
Indonesia; and
a swap premium in relation to certain export activities.

The difference in tax treatment has forced parties with loans, which pursuant to the
laws are not required to be reported to or confirmed by Bank Indonesia (such as onshore
foreign currency loans), to withhold tax on the premiums as if such premiums were interests.
Until the third amendment to the Income Tax Law became effective (on January 1
2001), regular swap premiums paid to non-residents are not taxable in Indonesia.
The current provisions of article 26 paragraph 1b of the Income Tax Law stipulate
that on income in the form of swap premium (elucidated as one related to an interest [rate]
swap) paid to non-residents will be subject to a withholding tax of 20% of the gross amount.
This elucidation has created new uncertainty for market participants over whether the
provisions of article 26 paragraph 1b of the Income Tax Law are limited so that premiums on
other swaps are not subject to the same tax treatment.

Tax treatment for credit derivatives

Payments made under credit derivatives would normally be subject to a general ruling on
taxation for general types of income and would not normally be deemed interest or amounts
in the nature of interest for interest withholding tax purposes because they are independent of
the interest on any underlying loan obligations. As mentioned above, any additional
economic capability in whatever name or form constitutes taxable income.

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