Research Details

Abstract

Financial claims are often taxed according to the way in which they are nominally "pack- aged" rather than according to their economic characteristics. We deconstruct financial tax- ation by viewing any financial strategy as a dynamic portfolio of pure debt and pure equity. Given the taxation of these building blocks, there is a unique consistent equivalent tax treat- ment for any strategy, and this transparent tax is a benchmark against which burdens or subsidies due to packaging can be measured. We quantify tax effects in present value terms in the context of a partial equilibrium model. We apply our methodology to common hybrid securities, such as convertible bonds and reverse convertible bonds. We find tax-induced discrepancies of up to about up to about 6% of value (i.e., 20 basis points per year) for typical 30-year convertible bonds. With unfunded securities, such as puts and calls, the dis- crepancy becomes much larger in percentage terms. Because these unfunded positions are levered, however, investors do not buy as many of them, and the discrepancy in aggregate absolute terms is therefore likely not so much greater. In our framework, the discrepancy can be eliminated either by taxation based on an ongoing determination of building block equivalents or else by eliminating distinctions in taxation among the building blocks. In particular, this would require eliminating the tax distinction between debt and equity.

Type

Working Paper

Author(s)

Thomas Joseph Brennan, Robert L. McDonald

Date Published

2014

Citations

Brennan, Thomas Joseph, and Robert L. McDonald. 2014. Deconstructing the Taxation of Packaged Financial Strategies.