1. Financial innovation / tax shelters and the income tax system PUBPOL 744 | Taro Nagao | Apr 16, 2007

2. 2 Agenda Realization Doctrine: Review Current income tax treatments on financial products Financial innovation (“put-call parity”) and its implication to the income tax policy Policy options on financial innovations Tax shelters and corporate tax avoidance Policy options on tax shelters

3. 3 Realization Doctrine: Review Haig-Simons Definition: Income = Consumption + "Net Increase in Wealth" Taxation on "Net Increase in Wealth" involves several problems - notably valuation and liquidity Therefore, Realization Doctrine is implemented in practice, where Taxes are paid at the time the asset is sold

4. 4 Taxation on financial products Traditionally two types of tax treatments Relied on a distinction between "fixed" and "contingent" returns to determine when income is taxed

5. 5 1) Fixed-return instruments Example: Bonds Characteristic: Return is known when purchased Tax treatment: Taxable amount is calculated annually on a yield-to-maturity basis

6. 6 Example Zero coupon bond, issued at $100, pay $133 in three years Yield to Maturity = 10% Taxable income: $10 is included in Year 1, $11 in Year 2, and $12 in Year 3 $10$11Taxable Amount:$12 $100 $133 1203 00Cash Income:$33

7. 7 1) Fixed-return instruments Example: Bonds Characteristic: Return is known when purchased Tax treatment: Taxable amount is calculated annually on a yield-to-maturity basis Rationale: The asset value will increase to a known amount, so yield-to-maturity is a financially reasonable way to distribute that income over time

8. 8 2) Contingent-return instruments Example: Stocks, derivative products (forwards/futures, options) Characteristics: Return is unknown when purchased Tax treatment: Taxation is deferred until sale ("wait-and-see" approach) Rationale: At purchase, you never know whether there is any gain or loss after certain period of time

9. 9 Summary So Far There are two basic types of tax treatment on financial instruments Relied on a distinction of characteristics (“fixed” vs. “contingent” return) The distinction works only if the two categories of assets are clearly distinguished and not interchangeable In fact, they are easily interchangeable!

10. 10 Financial Equivalences Financial equivalences sometimes permit one category of asset to be replicated using the other One example: Put-call parity theorem

11. 11 Put-Call Parity Theorem Call Option: The right to buy an asset for a certain price in the future Put Option: The right to sell an asset for a certain price in the future Difference between stocks and options = options have “optionality” If you own an option and the market moves unfavorably, you do not incur any loss

12. 12 Payoff ($) Future Stock Price ($)

13. 13 Payoff from stocks Payoff ($) Future Stock Price ($)

14. 14 Payoff from bonds Payoff ($) Future Stock Price ($)

15. 15 Payoff from call options X Payoff ($) Future Stock Price ($)

16. 16 Payoff from put options X Payoff ($) Future Stock Price ($)

17. 17 How do you get this payoff? Payoff ($) There are two ways: Buy Bond & Call Option Buy Stock & Put Option Future Stock Price ($)

18. 18 Put-Call Parity Theorem Stock + Put Option = Bond + Call Option Or, Bond = Stock + Put Option - Call Option (fixed) (contingent) (contingent) (contingent) If you own a bond but do not like its tax treatment, You can replace the bond with a stock, a put option and a short call option This undermines the income tax distinction between fixed and contingent return assets

19. 19 Summary So Far Modern financial theory has identified certain equivalences (e.g. Put-call parity) that allow different types of assets to be reconstructed in terms of each other Implication for income tax policy: these equivalences would undermine the fundamental distinction between assets that are treated differently for tax purposes There are many types of distinctions that can be undermined by financial innovations: –Character (ordinary income or capital gain) –Source (domestic or foreign)

20. 20 Policy options on financial innovations (Warren, 2002) 1) Transactional analysis 2) Taxation of changes in market value 3) Formulaic taxation 4) Anti-avoidance provisions

21. 21 1) Transactional analysis Analyze components of a new transaction in order to achieve consistent treatment with other, more familiar assets Example: convertible bond = bond & option to buy stock Pros: –Make economic sense Cons: –Reactive and ad hoc –“Repeated game”: taxpayers always find new loopholes –Make tax system complicated: away from the Haig- Simons ideal

22. 22 2) Mark-to-market taxation Directly measure "Net Increase in Wealth" Pros: –In line with Haig-Simons ideal Cons: –Valuation –Liquidity

23. 23 3) Formulaic Taxation Apply certain formulas/methods to compute tax Examples: –Retrospective taxation –Generalized cash-flow taxation Pros: –Achieve (or move toward) Haig-Simons ideal without measuring “Net Increase in Wealth” Cons: –GCFT: Different tax rate must be computed for each person every year based on his/her age

24. 24 4) Anti-avoidance provisions Disallow tax benefits in certain "tax- sheltering" transactions Need to define “tax-sheltering transaction”

25. 25 Summary So Far Tax system must be redesigned in response to financial innovations Four policy options are presented in Warren (2002): –Transactional analysis –Taxation of changes in market value –Formulaic taxation –Anti-avoidance provisions

26. 26 Tax Shelter Problem (Bankman, 2004) Definition: Tax shelter is best defined as –(1) tax motivated –(2) transaction unrelated to a taxpayer's normal business operations –(3) under a literal reading of some relevant legal authority –(4) produces a loss for tax purposes in excess of any economic loss –(5) in a manner inconsistent with legislative intent or purpose Example: "Short sales against the box"

27. 27 Tax shelter: Government weapons Amend the regulation upon which the shelter is based –Reactive and ad hoc –Taxpayers always find new loopholes –Complicated tax regulations Economic Substance Doctrine

28. 28 Economic Substance Doctrine Even a transaction that otherwise complies with a governing statute can be disregarded for tax purposes if it lacks significant non-tax motive or effect Provide speed/flexibility to government No predictability for taxpayers –What kind of transactions have “non-tax motive”? –How much substance must a transaction have?

29. 29 Economic Substance Doctrine – in practice Economic substance doctrine was almost uniformly upheld by courts, and the government won almost every case it brought against shelters However, The government did not have good success in finding shelters that were hidden in complex corporate returns

30. 30 Policy options on tax shelters (Bankman, 2004) Increase tax-book conformity; corporate taxpayers claiming tax losses were forced to recognize losses for financial accounting purposes Amend and replace economic substance doctrine with statutes based on newly-drawn definitions Raise the ex-ante cost of shelter by increasing penalties (short-term) Structural reform; Pure cash flow-based taxation (long-term)