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
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