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How might bond covenants influence a firm’s tax-planning activity? Provide an example for firms that use LIFO for inventory costing.
Managers are often concerned about the impact on reported profits of any actions recommended by the tax-planning department. Explain why.
If managers are compensated, in part, on the basis of a bonus based on accounting earnings, they are likely to object to any tax plans.
What are the tax benefits of deferring income recognition in advance of a decline in statutory tax rates? What, if any, are the nontax costs?
How might tax savings be sacrificed to achieve organizational design efficiencies or to mitigate political costs?
Suppose the tax rate is 0% for taxable income less than $0 (again no tax refunds for losses and no NOL carryback or carry-forwards).
Assume the firm’s after-tax cost of capital is 6% per annum. What is the benefit of deferring $1 of income for 1 year, for 2 years, and for 5 years.
If employers are risk-neutral and employees are risk-averse, why is a salary contract optimal, ignoring tax and asymmetric information considerations?
What is an “identification problem”? Illustrate conditions under which there might be an identification problem.
What role do hidden-action problems play in causing the borrowing rate for funds to be greater than the lending rate?
What is clientele-based arbitrage? Provide an example of such a strategy. Is clientele-based arbitrage restricted to high-tax-bracket taxpayers?
List some tax-rule restrictions that prevent organizational-form arbitrage. How do they succeed in preventing this arbitrage?
What restrictions are necessary to prevent pensions from being used in this manner?
What restrictions are in place to limit taxpayers’ abilities to avoid taxes from undertaking these strategies?
The bond has a remaining maturity of 5 years, promises to pay 6% interest annually (assume the coupon interest is payable annually).
If the before-tax rate of return on a riskless fully taxable bond is 7% and the before-tax rate of return on a riskless tax-favored asset is 5%.
Calculate the implicit and explicit tax rates for the following three assets. The required pretax total rate of return Ro for asset.
If half the interest earned on the savings portion of an insurance policy were taxable, would it still be possible for taxpayers.
What is the implicit tax rate on this strategy? How does it arise and where does it go? Would every taxpayer want to use this strategy?
What is the optimal investment (the one that maximizes after-tax income) over the range of investment from $0 to $500,000?
How would your answer change if the bonds matured in 30 years rather than in 20 years?
What impediments (both frictions and restrictions) exist to limit your ability to take advantage of this arbitrage possibility?
Assume you face a progressive tax rate system. Show that it does not pay for you to reduce your explicit tax rate on fully taxable income.
Assume you work for a local municipality. Further assume that there are no tax-rule restrictions preventing a municipality.
What is organizational-form arbitrage? Give an example of organizational-form arbitrage that would create infinite wealth for a taxpayer.