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

Debt

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

Writing a Call

Buying a Put

Selling a Put

Owning Stock

Shorting Stock

Payoff to Lending

Payoff to Borrowing

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 Call

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 –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