X Corp issues a bond that is due in 5 years. The bond has no coupon. The investor buys the bond for $100,000. In 5 years, the investor will receive $100,000 times the movement in the S&P 500 from the date the bond was issued until it matures. The most the investor can receive is capped at $200,000 and the investor is guaranteed to receive at least $10,000 even if the S&P goes down by more than 90%. The issuer could have borrowed money for five years at a 5% interest rate.
a. How will this instrument be treated for tax purposes?
b. Assume that it is redeemed at maturity for $175,000.
i. What is the amount of gain/loss?
ii. When and how will it be treated for tax purposes?
c. Assume that the investor was guaranteed to get her initial investment back at maturity, even if the S&P decreased in value. How would the amount received at maturity ($175,000) be treated?