A “credit default swap” secured transaction: the risk of its recharacterization into a suretyship agreement

Abstract

The article deals with two current situations when the Russian Bank (hereinafter — the Bank) is: 1) a provider; 2) a recipient of credit protection under an OTC derivative transaction “credit default swap” (hereinafter — CDS) that has the nature of security and is subject to both Russian or English law. It is emphasized that in these situations, Russian courts and tax authorities may carry out undesirable for the Bank reclassification of CDS transaction into the contract of guarantee. The paper provides for the description of consequences that may occur if the Bank implements that risk: 1) the Bank may be held responsible for illegal reduction of the tax base on income tax in the amount of credit protection paid by it on CDS; 2) a Russian court may refuse to satisfy the Bank’s claim to recover from the controlling person the amount of the debt on the principal obligation to the Bank in the amount of credit protection already received by the Bank provided that the Bank has received the amount of credit protection on CDS. It is concluded that in order to execute transactions that ensure proper fulfillment of the obligations of the controlling person to the recipient of credit protection, it is necessary to use a surety agreement or standard CDS terms and conditions, including a clause that such transactions are not derivative financial instruments.