Taxes and Financial Innovation

Overview

• Basic tax features & security design

• Debt versus equity, revisited

• Options & put-call parity

• Monetizing a gain

Basic Features of Income

• Timing– Realization (“wait-and-see”)– Accrual

• Character– Ordinary or capital– Dividend or interest

• Source (Foreign or Domestic)

Selective Realization & Tax Planning

• Lock-in effect– Time value of deferral

• Strategic trading– Hold winners, sell losers

Tax Rules as Inputs

• Portfolio design (or selection)– Tax arbitrage– Clienteles

• Security design– Same issues as portfolio design– Add new securities

Position DiagramsDebt vs. Equity

• Payoffs depend on the state of the world

• Simple 2-period model

• Equity has a different structure than debt

EquityPayoff

X

Slope = 1

X*

DebtPayoff

X

Slope = 1

X*

Economics

• Securities with returns that vary with performance are “equity”– Equity has flexibility

• Securities with relatively fixed payoffs are “debt”– Junior versus senior debt?– Junior debt versus preferred stock?

Taxation

• Debt– No tax on return of principal– No firm level tax; deductions on accrual– Investors taxed on accrual

• Equity– No tax on return of principal– Corporate tax– Investors taxed on dividends or capital gains

Security Design

• Create variable payoff securities that qualify as debt

• Convert relatively fixed payoff equity into being taxed as debt

Contingent Debt

• Contingent debt has variable payoffs– Floating interest rates (no big deal)– Commodity price based payoffs– Stock performance

• Index

• Another company

• Contingent interest or principal?

Taxation of Contingent Debt

• Control features matter

• Contingencies are important

• Original issue discount portion

• Settling up at the end

Disney’s Participation Notes

• Minimum interest payment

• Revenue contingent payment

• “Penalties” for not making movies

• Cap on total payoff

Disney Notes

• Payoff diagram?

• Explain features of the contract?

• Tax advantage of the contract?– Alternative sources of funds?

Monthly Income Preferred Stock

• Trust preferred, etc.

• Converting “safe” equity into debt for tax purposes

• Add an intermediary between the firm and the investors

Non-Unique Cash Flows

• Position diagrams = options

• Derivatives = many copies

• Non-tax analysis

• Taxation

Assumptions for Options

• Common expiration date, T

• Common exercise price, k

• No early exercise

• Stock price, S

• Position diagrams of future cash flows (ignore sunk costs!)

• No transaction costs

Buying a CallPayoff

ST

Slope = 1

k

Writing a CallPayoff

ST

Slope = -1

k

Buying a PutPayoff

ST

Slope = -1

k

Selling a PutPayoff

ST

Slope = 1

k

Owning StockPayoff

ST

Slope = 1

k

Shorting StockPayoff

ST

Slope = -1

k

Payoff to LendingPayoff

ST

Slope = 0

k

Payoff to BorrowingPayoff

ST

Slope = 0

k

Taxation of Options

• Recall from PS #2

• Realization-based taxation

• Premium affects basis

• Often capital in character

• Avoids withholding taxes

Put-Call Parity

• What is the position diagram for owning a share, buying a put, and writing a call?

• Replicates lending

• Implications for no arbitrage asset pricing?

• Implications for option prices?

Share, Put and Short CallPayoff

ST

Slope = 0

k

Put-Call Parity & Taxation

• S + P - C = B

• Everything on the left is taxed on realization but the bond is taxed on accrual

• Same pre-tax cash flows; different taxesOOPS!

Routes around Realization

• Shorting-against-the-box– Investor shorts a stock already in portfolio– Borrows stock from broker– Eliminates “risk”– Until 1997, not deemed a realization event

• “Portfolio” of derivatives -- puts & calls

Monetizing a Gain

• Eli Broad has substantial SunAmerica stock

• Large capital gain

• Wants cash & possibly diversification

• Does not want to pay capital gains tax

• Solution: Strypes

• Structured yield product exchangable for common stock

Strypes

• Buyer pays $56, roughly the SunAmerica share price

• Buyer “receives”– Interest payments of 6.75% of $56 for 3 years– Value of SunAmerica if less than $76 OR $76

if share price > $76– Does not receive the dividends

Decompose Strypes

• Buyer pays $56 for a portfolio of:– SunAmerica share (no voting rights)– Writes a 3-year call option, strike = $76– “Swaps” dividend for 6.75% fixed interest

• At year 3, buyer must sell security

• Decomposition is not unique

Strypes: Issuer’s Perspective

• Retains voting control

• Might get interest deductions (corporate issuer might even get the DRD)

• Avoids (defers) tax on capital gain

• Retains upside potential

• Sheds downside risk