TaxSheltersLecture

TaxSheltersLecture - Tax Shelters and Financial Innovation...

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1 Tax Shelters and Financial Innovation Tax Shelters Definition Example: “high-basis, low-value” strategy The “undersheltering” puzzle Financial Innovation and the Income Tax System Example: the put-call parity theorem and tax law distinctions
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2 Tax Shelters Difficult to define precisely, but generally involves: Tax-motivated transaction What about buying a house? Unrelated to normal business operations Literal reading of the law Lack of “economic substance” Recall Knetsch Inconsistent with legislative intent Inherently subjective notion
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3 Tax Shelters In recent years, attention has been focused on corporate (rather than individual) shelters How does the government combat tax shelters? Various approaches: Economic substance doctrine Ad hoc revisions to tax law (“closing loopholes”) Penalties
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4 A (Relatively) Simple Example “High-basis, low-value” strategy Based on description in Bankman (1999, 2004) Widely used in the 1990’s Involves 2 parties: US-based corporation (X) Bermuda-based corporation (B) Note that Bermuda is a “tax haven” (it imposes a zero rate of corporate tax)
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5 A (Relatively) Simple Example At time 0, X anticipates having $80 of taxable income at time 1 At time 0, B takes a perfectly hedged position in the stock of Y (a corporation located in a third country where B does not do business) Y’s stock price is expected to: ↑ from $1 to $1.80 per share with prob ½ ↓ from $1 to $0.20 per share with prob ½ from time 0 to time 1
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6 A (Relatively) Simple Example At time 0, B takes a long position of 100 shares in Y and a short position of 100 shares in Y At time 1, suppose that Y’s stock has fallen in value Then, B has an appreciated short position (gain = $80) and a loss of $80 on the long position
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7 A (Relatively) Simple Example X sets up a subsidiary S, which it initially owns
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TaxSheltersLecture - Tax Shelters and Financial Innovation...

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