Geared equity investments: a case study of tax arbitrage down under

Australian Journal of Management, June, 2003 by Charles J. Corrado, Joe Cheung

Abstract:

Geared Equity Investment (GE1) contracts are an over-the-counter financial derivative product offered by Macquarie Bank, Ltd. to individual investors in Australia and New Zealand as a managed-risk investment in local shares carrying significant tax shield benefits. Upon issuance, a geared equity contract has three stakeholders: (1) the investor; (2) the issuer; and (3) the national tax authority. We assess the value of these contracts to each stakeholder and their support for tax arbitrage. We find that the national tax authority provides a significant subsidy to GEI contracts via tax shield benefits. These benefits support investor tax arbitrage in certain cases and issuer tax arbitrage in all cases examined.

Keywords:

OPTION VALUATION; TAX ARBITRAGE; GEARED EQUITY INVESTMENTS.

1. Introduction

'The power to tax involves the power to destroy' (Marshall 1819). By natural extension, the power to exempt from tax involves the power to create. Governments typically engage in policies to exempt from tax investment activities they wish to promote. For example, Australia and New Zealand use dividend 'franking' to reduce income tax paid by domestic residents on dividends received from domestic corporations, thereby encouraging investment in shares of local companies. (1) Australia and New Zealand also offer partial or complete tax exemption on long-term capital gains realised from direct shareholdings. (2) By contrast, gains on shares held indirectly in managed funds may be taxed before realisation through annual assessments, thereby encouraging direct shareholdings. (3,4)

This paper is a case study of an innovative financial derivative contract that facilitates tax arbitrage by individual investors in Australian and New Zealand. 'Geared Equity Investments' (GEI) are offered by Macquarie Bank, Ltd. of Australia to high-income individual investors with a tax residence in Australia or New Zealand. These contracts provide a 100% margin loan facility to purchase shares of selected Australian or New Zealand companies and an embedded put option to insure the investor against any loss on funds borrowed through the contract's loan facility. Major features of the investment and taxation environments of Australia and New Zealand supporting these contracts include: (i)steeply progressive marginal income tax rates; (ii)deductibility of investment interest expense from assessable income; (iii) favourable tax treatment of long-term capital gains; and (iv)absence of a legally mandated initial margin requirement on the purchase of common shares.

Previous research specifically focused on Macquarie's geared equity products appears limited to an article by Gray and Whaley (1999) that focuses on the value of a strike price reset feature attached to some geared equity contracts. The authors conclude that the reset feature was underpriced. Perhaps not coincidentally, the reset feature has been discontinued by Macquarie since dissemination of their interesting article. (5) Kat (2000) examines a similar product available to Dutch investors and concludes that the profit margin to the issuer is substantial. There is also an interesting stream of case study research on special products that identify and value embedded options in an Australian context. Significant contributions to this stream include Duncan and Easton (2000), Duncan and Easton (2002), Easton and Pinder (1998), Easton and Pinder (2000), and Pinder (1998).

We examine the generic (sans reset) geared equity investment (GEI) contract still actively promoted by Macquarie to investors who are tax residents of Australia or New Zealand. The purpose of this paper is to assess the value of a GEI contract to each of its three stakeholders: (i)the individual investor; (ii)the issuer, Macquarie; and (iii) the national tax authorities of Australia and New Zealand, the Australian Tax Office (ATO) and the Inland Revenue Department (IRD), respectively. In particular, we examine the degree to which the GEI contract supports tax arbitrage by the investor and the issuer. Our conclusions have an obvious interest to those involved in the research and design of over-the-counter financial derivative products, as well as, of course, potential investors in geared equity contracts. Moreover, the discussion herein also has direct relevance to the tax authorities of Australia, New Zealand, and other countries where similar products might be available.

The paper is sequenced as follows: We first provide an overview of the Macquarie geared equity investment contract and its tax shield benefits. Assumptions and a description of valuation methodology come next. We then analyse the valuation properties of the geared equity investment contract. The final section contains our summary and conclusion.

2. Overview of the Geared Equity Investment (GEI)

2.1 Basic Structure, Costs and Tax Benefits

The Macquarie geared equity investment (GEI) contract establishes a loan facility to purchase shares in selected Australian and New Zealand companies (Macquarie 2000). To facilitate exposition we assume a $100,000 contract size, where contract size specifies the amount of loan principal. At contract initiation, loan proceeds are used to purchase common shares of companies listed on the Australian Stock Exchange (ASX) or New Zealand Stock Exchange (NZSE).