Deconstructing the Taxation of Packaged Financial Strategies

48 Pages Posted: 5 May 2015

Date Written: August 18, 2014

Abstract

Financial claims are often taxed according to the way in which they are nominally “packaged” rather than according to their economic characteristics. We deconstruct financial taxation 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 treatment 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 discrepancy 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.

Keywords: debt-equity distinction, hybrid taxation, convertible bond taxation, tax arbitrage

JEL Classification: G12, H24, H25, K34

Suggested Citation

Brennan, Thomas J. and McDonald, Robert L., Deconstructing the Taxation of Packaged Financial Strategies (August 18, 2014). Available at SSRN: https://ssrn.com/abstract=2602621 or http://dx.doi.org/10.2139/ssrn.2602621

Thomas J. Brennan (Contact Author)

Harvard Law School ( email )

1557 Massachusetts Ave
6 Ever
Cambridge, MA 02138
United States
617-495-3141 (Phone)

Robert L. McDonald

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8344 (Phone)
847-491-5719 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
144
Abstract Views
1,519
rank
272,216
PlumX Metrics