The Phantom Tax and IRS Pinheads

I'm doing a 4000 level finance class this spring, and the topic that engendered the most debate is the "phantom tax". Go figure. Anyway, if it interests them, perhaps it will interest you too.

The phantom tax is imposed on the "interest paid" on longer term corporate discount bonds (zeros).

Here's where it gets tricky: 1) you often have to pay the tax before you get paid the interest, and 2) you can even have to pay the tax in a situation where you'll never collect the interest. Maybe its more of a vampire tax ... anyway, it's a good but long story.

To get to the bottom of this I first have to explain how bonds work. Many bonds come with a coupon. This is a constant amount that the bond will pay every period (say, a year). The coupon divided by the current price is the interest rate on the bond. As interest rates out in the market rise, the price of a bond falls to keep its interest rate in line with that of the market (and when rates fall prices rise). The bond also has a face value, which is the amount you get to redeem it for at the time it matures. The current price can get quite far away from that face value, but it will tend to be closer as you approach that maturity date.

For example, a 10 year bond might be issued with a $50 annual coupon and a $1000 face value. The key here is that you get your money back in two ways. There is a notional interest rate here of 5% (50/1000) which isn't really relevant. What's important is that if the interest rate in the market (say) rises, the coupon payments on this bond no longer look very good. People who bought the bonds primarily for the interest they get paid through the coupons will try to get out of them and their price falls. The people who pick up those bonds do so because they aren't as worried about the interest from the coupons; they buy because they want to a chance at cashing in for the face value, and are more willing to do so when the price of the bond is lower. Here's the trick: the smaller the coupon, the bigger that price swing will have to be to get people to buy the bond for the face value (because, even so, they still like getting the coupon).

This leads us to discount bonds. These are bonds that pay no coupon at all. You get all of your investment return from the face value. They're called discount bonds because you buy them at a discount from the face value. For example, you might pay $900 today for a bond that will pay you $1,000 in a year. It's a little like getting one big coupon at the end.

Lots of institutions sell discount bonds; our government sells billions of dollars worth every day. But ... most of them are sold for short periods of time, like weeks or months.

But, in the 1970s, J.C. Penney decided to sell a longer term corporate discount bond. These became known as zeros (because they have zero coupon). The key points with these were that they were corporate - so there was no favorable tax treatment for an investor - and that their term was long enough that it covered more than one year for tax purposes.

For example, if the going rate was 9.6%, and you were going to buy a bond that paid you $1,000 ten years from now, you'd be interested in paying $400 for it now, and collecting $600 in "interest" when you redeemed the bond in 2016.

Now. investors said to themselves - somewhat reasonably - that this is like a capital gain, and the capital gains tax rate should apply. The IRS said - somewhat reasonably - that this is still a bond on which you earn income and the income tax rate should apply. Of course, the IRS won the argument.

But, the IRS is full of pinheads, and this is where the phantom tax comes in. The IRS said that you don't owe income tax on the $600 when it is paid in 2016, rather, you owe income tax on the interest that would have been paid incrementally each year (as if this was a coupon bond) even though you haven't received that income yet.

For example, there are formulas that show that if the interest rate doesn't change, that after a year the price for this bond will rise to $438 (when nothing changes but the length of time to maturity, the price goes up because it has to reach $1000 on the day the bond comes due). The IRS says you owe income tax on that $38 after the first year (and on the $42 you'll get in the second year, and so on).

It's called a phantom tax because you haven't actually gotten that $38 yet. The only way to get it is to sell the bond. But, the IRS says you owe tax on that "phantom" income whether you sell the bond or not.

It gets worse. The IRS says you owe income tax on the $38 even if the market interest rate changes. If rates fall, the price of your bond (if you choose to sell it) will be greater than $438, but you still owe the tax. This might actually be beneficial to you. The flip side is a problem though: if the interest rate rises, and the price of the bond falls, you still owe the income tax on the $38 "interest" that not only haven't you gotten, but now you don't even have it in on paper because your bond has lost value!

Now, I mentioned IRS pinheads above, and that requires an explanation. The IRS is reasonable in treating this as "income", but I think they step over the bounds in requiring that you pay tax on it every year. But ... they do this because they are obsessed (as is the government in general) about cash flows on an annual basis. This is small minded. Corporate professionals have known how to rearrange cash flows to meet any desired pattern for decades, and in some cases centuries. You'd think the IRS would figure this out. They could even do something like sell the stripped payment of taxes to an entitiy that would give them all the money up front. But noooooo ...

I really think this is a good justification for the viewpoint that the IRS was designed for, and is filled with, control freaks. It is one thing to want to control cash flows internally. It is quite another thing when faced with two choices - either to manage your cash flows, or to control someone else's cash flows - to choose the latter.

Comments

[The Unknown Professor]

This is one reason why most zero's are held in tax-qualified plas (i.e. pension funds, IRAs, etc...).

Since earnigs of these plans are shielded from federal taxation until removes, then"hantom tax" is largely irrelevent.

But I second your thoughts on the IRS. When I talk about taxes, I discuss some of the many "weirdities" of our tax system. I tell the class, "I'd like to see a picture of the guy who devised our tax system. I bet he looks funny."

[Dave Tufte]

Sorry this took so long to reply to.

As an economist (primarily), I'd turn this point around and say that it is far from irrelevant - we now have a basis for saying that tax-qualified plans have flourished because of tax "weirdities". Is this a business the IRS should be in?

P.S. I like your joke.

P.P.S. My equivalent is that when I talk about people who are innovators, I note that I don't think they take enough showers.

[The Unknown Professor]

I'd buy that idea that tax-qualified plans flourishe in part because of "tax weirdities".

A lot of financial innovations come about because of what I call "regulatory arbitrage" (exploiting the seams in regulations). For example, there's a recent posting in Bill Burnham's blog on 3/13 on "Dividend Recaps" at

http://billburnham.blogs.com/burnhamsbeat/2006/03/dividend_recaps.html

Much (maybe most)of the phenomenon is due to hedge fund managers' inentives (i.e. their compensation structure), but the tax angle probably also plays a big part.

As for the joke, any time I can get a laugh in class, I go for it. Unfortunately, I have a shortage of good material. At some point (post tenure, of course), I'll probably write an article compiling the jokes finance profs use to illustrate common financial concepts (kind of a "best finance humor practices").

If nothing else, I'd get better material.

This will be a true test to see just how smart the voters of Illinois are. If you let your elected officials raise taxes to make up for their wasteful and excessive spending habits, then you deserve everything that you have coming to you. It amazes me that people still believe that the government knows how to spend their money better than they do. Do you ever see a politician losing their home or not being able to go on vacation? Yeah, me neither-- and that bothers me that our elected officials are so...