Everything You Need to Know about Tax
Arbitrage
• Definition of tax arbitrage: purchase of one asset (going
long) and sale of another (going short) and creating a
sure (sometimes there can be risk) profit. Profit comes
from the spread created by different tax treatments
afforded the long and short positions.
• Two types of arbitrage are organizational and clientele
based.
• Clientele based arbitrage strategies are dependent on
MTR. Implicit and explicit tax benefits exceed implicit
and explicit tax costs.
• Clientele based arbitrage will be successful when
implicit MTR < Explicit marginal tax rate.
• Organizational-form arbitrage takes advantage of
differences in the way assets are taxed inside different
organizational or investment structures
• Transactions costs and other frictions limit arbitrage
possibilities.
• If frictions are not large, tax arbitrage will occur until the
IRS finds out about it. For this reason, tax planners are
very secretive and arbitrage opportunities only come out
after they are no longer viable.
• Popularity of derivatives has lessened frictions
associated with tax arbitrage. Many new derivative
instruments are tax motivated.
Current Arbitrage Opportunities that Still Work
• Corporate
• Buying and Issuing Preferred Stock. Proposal to limit
DRD to 50%.
• Using Tax Exempt Bonds as short term corporate cash
management strategy
• Certain Types of Corporate Owned Life Insurance
(COLI)
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•
•
•
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Individual
Leverage Granny’s Stock Portfolio (limit $100k)
Home Buying (limit $1.1 million)
Borrow Roth IRA Contributions (limit $100k)
Buy stock before ex-dividend date and sell after. Use ST
capital loss to offset ST capital gain.
• Borrow using home equity loan ($100k limit) to invest in
dividend paying stocks.
• Borrow up to $ 1.1 million indirectly to purchase taxexempt securities when you purchase a home in the
River Bottoms.
Corporate Arbitrage
Using Preferred Stock
High MTR
Taxpayer
Low MTR
Taxpayer
Cash
See-Jay
Corporation
Wood-E Corp.
Preferred
Stock
Bonds
Cash
Debtors
(bondholders)
Cash
Taxable
Bonds
Debt
Issuer
Importance of Marginal Tax Rates
Why are marginal tax rates important in the Scholes and
Wolfson Framework?
• Used to compare the after-tax profitability of alternatives
• Used to identify tax planning opportunities (purchase of
municipal vs. taxable bonds, sale leaseback, clientele
based arbitrage, etc.)
• So far we have been using Level 1 Marginal tax rate
(explicit tax applied to next dollar of income). But it is
subject to limitations.
• Unless an individual or firm are already in the top
marginal bracket, a large increase in income will be
subject to multiple marginal rates complicating the
computation of ATCFs
Example:
Suppose a corporation is currently producing net income of
$75,000 is considering an alternative which would increase
taxable income by $75,000. What is the change in ATCF?
Will the algebraic approach to determining ATCFs work?
• Taxable Income rises and falls over time because of
NOLs, large one-year deductions from R&D,
acquisition of plant and equipment, restructuring costs
etc.
• Future legislation
• Phaseouts of deductions for individuals and alternative
minimum taxes
• Strategy Dependent MTRs (a tax planning strategy
can affect MTRs)
• How do NOL carryovers affect the computation of
MTRs?
• Tax Treatment of NOLs
• Corporations can carryback 2 years or forward 20 years
provided the corporation had income in the carryback or
will have income in the carryforward years
• May elect of forego the carryback
Example:
Assume U Corp has $100,000 NOL in 1999 and taxable
income of $90,000 in 1997, and $10,000 in 1998. U Corp
will carryback the NOL first. What are the tax
consequences (use corporate rate schedule)?
How would the problem change if U Corp elects to
carryover the losses assuming you forecast that U Corp will
generate taxable income of $200,000 per year for the next 5
years?
How would you decide to select option 1 or 2 assuming rc
= .10?
• When a company has NOLs, MTR is the present value of
the explicit tax increase on the next dollar of income
• MTR in a NOL year is not 0
If U Corp elects to carryforward NOL, what is its marginal
tax rate in 1999? Would your answer change if the NOL in
1999 was $250,000?
• What affects the computation of MTR in NOL years?
• After tax discount rate (rc)
• How far into the future NOL must be carried
• Expected tax rates in future years
• Expected future income stream
• The size of the NOL itself
• How are these factors reflected in the formula for
MTRs?
Tax Planning in an Uncertain World
• Computing MTRs can be difficult. To the extent it is
difficult, tax planning (clientele based arbitrage and other
MTR dependent strategies) may be curbed.
• Today’s case only examined 1 period
• Strategies didn’t affect timing of NOL usage
• Strategies didn’t affect MTR (flat rate assumed)
• Only considered one NOL carryforward
• In can be costly to switch from MTR dependent tax strategies
as the future unfolds. How do firms deal with this?
• Pursue tax reducing strategies that can be changed with the
least amount of cost.
• Implement other dynamic tax planning strategies.
• While the case dealt with clientele based arbitrage as a
planning strategy, others could work here as well.
• Current vs. deferred compensation
• Purchase or lease equipment
• Debt vs. Equity Financing
• Types of uncertainty tax planners must grapple with:
•
Uncertain Future Cash Flows (Affect of MTR)
•
Uncertainty as to Future Tax Law
•
Interpretation Uncertainty
• In the face of uncertainty, tax planners must make
decisions such as:
•
Lease or Buy (Depends on future MTR)
•
Issue Debt or Equity (Depends on future MTR)
• Because it can be costly to be in the wrong clientele,
planners can preserve flexibility (minimize costs of
switching out of wrong clientele) by:
•
Building reversibility into tax plan
•
Building adaptability into tax plan
•
Insuring against adverse changes in tax status
•
Flexibility is not free i.e., long term vs. short term
bonds
• Reversibility
•
Closely held Corps
•
Muny Bonds
•
Preferred Stock with mandatory redemption
• Adaptability (Consider when reversibility not possible)
•
If MTR drops, may be difficult to sell off depreciable
assets, but may consider selling off municipal bonds
and replacing with taxables.
•
Issue short term securities of callable securities (must
trade off costs with additional flexibility)
•
De facto partnerships
• Insurance against adverse changes in tax status
•
Letter Rulings. Risky because may alert IRS to plan or
may be unfavorable. (Interpretation uncertainty)
•
Buy opinion. Tax shelters, derivative instruments, etc.
(Interpretation uncertainty)
•
Tax Indemnities i.e. WSJ article, Industrial Revenue
Bonds, Tax Shelters, etc (law change uncertainty).
•
Hedging—take long position in securities that will rise
if law changes or short position in securities that will
fall. Opportunity for creation of tax motivated
derivative instruments.