Geared Equity Investments: A Case Study of Tax Arbitrage Down Under

Abstract

Geared Equity Investment (GEI) 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

Get full access to this article

View all access options for this article.

References

Australian Taxation Office, 1999, Guide to Capital Gains Tax, (ATO pamphlet).

Australian Taxation Office, 2000. Income Tax: Deductibility of Interest on Borrowings Under the Macquarie Geared Equities Investment Facility. (2001 update to ATO product ruling. PR 2000/70).

Black, F. & Scholes, M. 1973, ‘The pricing options and corporate liabilities’ , Journal of Political Economy, vol. 81. pp. 637–54.

Boyle, G. 1996. ‘Corporate investment and dividend tax imputation’ . The Financial Review, vol. 31. pp. 209–26.

Cliffe, C. & Marsden, A. 1992. ‘The effect of dividend imputation on company financing decisions and the cost of capital in New Zealand’ , Pacific Accounting Review, vol. 4, pp. 1–30.

Cox, J. C. , & Rubinstein, M. 1985. Option Markets, Prentice-Hall, Englewood Cliffs. NJ.

Duncan, P. , & Easton, S. 2000, ‘An empirical investigation into the pricing of New South Wales and Victorian Electricity Futures Contracts’ , Accounting Research Journal, vol. 13. pp. 44–50.

Duncan, P. & Easton, S. 2002, ‘The pricing of high yield equity notes’, Accounting and Finance, forthcoming.

Easton, S. , & Pinder, S. 1998, ‘The pricing of low exercise price options” , Australian Journal of Management, vol. 23, pp. 203–12.

10.

Easton, S. , & Pinder, S. 2000, ‘The demutualisation of AMP society: An example of the valuation of collars comprising Asian options’ , Australian Journal of Management, vol. 25, pp. 283–98.

11.

Gray, S. F. , & Whaley, R. E. 1999. ‘Reset put options: Valuation, risk characteristics and an application’ . Australian Journal of Management, vol, 24, p. 1–20.

12.

Harrison, J. M. , & Pliska. S. R. 1981. ‘Martingales and stochastic integrals in the theory of continuous trading’ . Stochastic Processes and Their Applications, vol. 11, pp. 215–60.

13.

Hull, J. 1999, Futures and Options Markets, Prentice-Hall, New Jersey.

14.

Inland Revenue Department, 1992, Tax Information Bulletin. IRD, vol. 3, no. 9, June.

15.

Inland Revenue Department, 1995, Non-Resident Withholding Taxpayer's Guide. IRD 291.

16.

Inland Revenue Department, 1996, IRD Product Ruling, IRD-BR/PRD/96/4.

17.

Inland Revenue Department, 2000, IRD Publication, IRD, no. 291A, March.

18.

Internal Revenue Service, 1999, Investment Income and Expenses. IRS 550.

19.

Kat, H. 2000, ‘Equity-linked saving: A new product range for retail investors’ . Journal of Alternative Investments, vol. 3, pp. 29–43.

20.

Macquarie Bank . 2000, Geared Equities Investment. Macquarie Ltd .

21.

Marshall. John , Chief Justice U.S. Supreme Court, 1819, McCulloch v. Maryland .

22.

Merton, R. C. 1973, ‘Theory of rational option pricing’ , Bell Journal of Economics and Management Science, vol. 4, pp. 141–83.

23.

Pinder, S. 1998, ‘The relative pricing of Commonwealth Bank shares and instalment receipts’ , Accounting Research Journal, vol. 11, pp. 293–97.

24.

Stoll, H. R. , & Whaley, R. E. 1993. Futures and Options: Theory and Applications, Southwestern Publishing, Cincinnati, OH.

25.

Wood, J. 1997, ‘A simple model for pricing imputation tax credits under Australia's divided imputation tax system’ . Pacific-Basin Finance Journal, vol. 5, pp. 465–80.

26.

Note: Cited publications from the Australian Tax Office, New Zealand Inland Revenue Department, and the United States Internal Revenue Service are available at their respective websites (www.ato.gov.au, www.ird.govt.nz, www.irs.ustreas.gov).