Reference no: EM131696991

Question: Foreigners buying Australian dollar instruments issued in Australia have to pay withholding taxes on interest earnings. This withholding tax can be exploited in tax-arbitrage portfolios using swaps and bonds. First let us consider an episode from the markets related to this issue. Under Australia's withholding tax regime, resident issuers have been relegated to second cousin status compared with nonresident issuers in both the domestic and international markets. Something has to change. In the domestic market, bond offerings from resident issuers incur the 10% withholding tax. Domestic offerings from nonresident issuers, commonly known as Kangaroo bonds, do not incur withholding tax because the income is sourced from overseas.

This raises the spectre of international issuers crowding out local issuers from their own markets. In the international arena, punitive tax rules restricting coupon washing have reduced foreign investor interest in Commonwealth government securities and semigovernment bonds. This has facilitated the growth of global Australian dollar offerings by Triple A-rated issuers such as Fannie Mae, which offer foreign investors an attractive tax-free alternative. The impact of the tax regime is aptly demonstrated in the secondary market. Exchangeable issues in the international markets from both Queensland Treasury Corporation and Treasury Corporation of NSW are presently trading through comparable domestic issues. These exchangeable issues are exempt from withholding tax. If Australia wishes to develop into an international financial center, domestic borrowers must have unfettered access to the international capital markets-which means compliance costs and uncertainty over tax treatment must be minimized. Moreover, for the Australian domestic debt markets to continue to develop, the inequitable tax treatment between domestic and foreign issues must be corrected (Thomson Reuters IFR, Issue 1206). We now consider a series of questions dealing with this problem. First, take a 4-year straight coupon bond issued by a local government that pays interest annually. We let the coupon rate be denoted by c%. Next, consider an Aussie$ Eurobond issued at the same time by a Spanish company. The Eurobond has a coupon rate d%. The Spanish company will use the funds domestically in Spain. Finally, you know that interest rate swaps or FRAs in Aussie$ are not subject to any tax.

a. Would a foreign investor have to pay the withholding tax on the Eurobond? Why or why not?

b. Suppose the Aussie$ IRSs are trading at a swap rate of d 110 bp. Design a 4-year interest rate swap that will benefit from tax arbitrage. Display the relevant cash flows.

c. If the swap notional is denoted by N, how much would the tax-arbitrage yield?

d. Can you benefit from the same tax arbitrage using a strip of FRAs in Aussie$?

e. Which arbitrage portfolio would you prefer, swaps or FRAs? For what reasons?

f. Where do you think it is more profitable for the Spanish company to issue bonds under these conditions, in Australian domestic markets or in Euromarkets? Explain.