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 Diagrams
Debt vs. Equity
• Payoffs depend on the state of the world
• Simple 2-period model
• Equity has a different structure than debt
Equity
Payoff
Slope = 1
X*
X
Debt
Payoff
Slope = 1
X*
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 Call
Payoff
Slope = 1
k
ST
Writing a Call
Payoff
k
ST
Slope = -1
Buying a Put
Payoff
Slope = -1
k
ST
Selling a Put
Payoff
k
ST
Slope = 1
Owning Stock
Payoff
Slope = 1
k
ST
Shorting Stock
Payoff
k
ST
Slope = -1
Payoff to Lending
Payoff
Slope = 0
k
ST
Payoff to Borrowing
Payoff
k
ST
Slope = 0
Taxation of Options
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•
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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 Call
Payoff
Slope = 0
k
ST
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 taxes
OOPS!
Routes around Realization
• Shorting-against-the-box
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–
–
–
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
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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