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Tax Planning Using Derivative Instruments and Firm Market

Valuation Under Clean Surplus Accounting
By
Tao Zeng
A thesis submitted to the School o f Business in conformity

with the requirements for the degree o f Doctor
o f Philosophy in Management
Queens University
Kingston, Ontario, Canada
January, 2001
Copyright @Tao Zeng, 2001
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Abstract
The use o f derivative financial instruments in the past decade has made it flexible and
efficient for firms to manage taxation. Derivative financial instruments can affect taxes by altering
the timing and character o f reported income subject to tax. In this thesis, we set up a theoretical
framework to show how firms exploit tax-timing and tax-character options to enhance firm market
value. Firms exploit tax-timing options when they realize losses immediately but defer gains
indefinitely. They exploit tax-character options when they realize losses as ordinary losses rather
than capital losses. Firms can exploit both tax-timing and tax-character options by using derivative
financial instruments. Data collected from the EDGAR database o f the U.S. industrial firms tends
to support the hypothesis that firms use derivatives to exploit tax-timing options. We also examine
how taxation affects firm market valuation under clean surplus accounting. Under corporate taxation,
based on the Feltham-Ohlson (1995) market value measurement model, we show that firm market
value can be expressed as the bottom line accounting data, i.e., the book value and the abnormal
earnings, as well as the tax data - tax-based market valuation model. The tax-based market valuation
model provides a theoretical framework for the analysis o f the effects o f corporate taxation on firm
market value. Firms may use derivatives to save tax by exploiting tax-timing and tax-character
option value, and thus enhance market value. Agency costs such as financial reporting costs may
reduce, but may not eliminate the benefits from exploiting tax-timing and tax-character option value.
Acknowledgements
I sincerely thank my thesis proposal committee for their many comments and suggestions.
I also thank the Ph.D. students who offered help and advice. In particular, I would like to thank my
supervisor, Daniel Thornton, who gave me a great deal of help in finishing my thesis. Also, I thank
Glenn Feltham, James Gaa, Norman Macintosh, Latha Shanker, and Ping Zhang for their valuable
suggestions.
Tao Zeng
Queens University
ii
Contents
Chapter One: Introduction

1.1 Tax Consequences of Using Derivatives (Topic of Interest).................................................. 1
1.2 Contributions of the T h esis........................................................................................................... 4
1.3 Organization o f the T h esis............................................................................................................ 5
Chapter Two: Literature Review

2.1 Literature Related to Tax-timing Issu es.................................................................................... 7
2.1.1 Using Derivatives Poses Challenges for the Tax System ........................................ 7
2.1.2 Theoretical W ork Involving Tax-timing Options.................................................... 9
2.1.3 Empirical W ork Involving Tax-timing Options.................................................... 14
2.1.4 Sum m ary..........................................................................................................................17
2.2 Literature Related to Tax-character Issu es.............................................................................17
2.3 Literature Related to the Effect o f Taxes on Firm Valuation under Clean
Surplus Accounting.................................................................................................................20
2.3.1 Feltham - Ohlson M odel Relating Firm Value to Accounting Data
in a Neoclassical S ettin g .............................................................................................20
2.3.2 With Corporate Taxation, Tax-saving Strategies Affect Firm Market Value... 22
2.4.3 Sum m ary..........................................................................................................................26
2.4 Conclusion.................
26
Chapter Three: Tax-Timing Option and Tax-Character

Option Value Using Derivatives
3.1 Introduction................................................................................................................................... 27
3.2 Valuation Framework................................................................................................................. 28
3.3 Security Holder Tax-timing O ption......................................................................................... 32
3.4 An Illustrative Exam ple..............................................................................................................36
3.5 Security Holder Tax-character O ption.................................................................................... 40
3.6 Minimizing Corporate Income Taxes Using Derivatives..................................................... 42
3.6.1 Analytical Framework.................................................................................................. 43
3.6.2 Three Examples.............................................................................................................46
3.7 Empirical Evidence on Corporate Use of Derivatives to Manage Taxes............................. 48
3.7.1 Predictions to be Tested............................................................................................... 49
3.7.2 Sample Selection and Variable M easurement............................................... 50
3.7.3 Model and Results......................................................................
56
3.7.4 Summary and Limitation............................................................................................57

3.8 Conclusions and Limitations...................................................................................................... 59
Chapter Four: Effect of Taxes on Firm Valuation Under

Clean Surplus Accounting
4.1 Introduction................................................................................................................................... 60
4.2 Relevant Accounting under Feltham-Ohlson M odel
................61
4.3 Tax-based Market Valuation Framework................................................................................. 62

iv
4.3.1 Accounting Relations................................................................................................ ..

4.3.2 Firms Market Value and Its Relation with Clean Surplus Accounting Data....66
4.3.3 Dynamic Linear Information Model.........................................................................70
4.3.4 Empirical Implications................................................................................................ 73
4.4 Accounting Implication of Tax-planning Strategy Exploiting Tax-timing Option Value...74
4.4.1 Two-Period C ase......................................................................................................... 74
4.4.2 Tax Strategy Using Derivatives................................................................................76
4.4.3 Some Extensions of the Two-period M odel............................................................78
(i) An Analysis of the Trade off between Tax-timing Option
and Financial Reporting C osts..........................................................................78
(ii) Tax Accruals for Each Period Are Not Fixed...............................................82
4.5 Accounting Implication of Tax-planning Strategy Exploiting Tax-character
Option Value................................................................................................................................... 84
4.6 Conclusion...........................................................................................- .......................................85
Chapter Five: Conclusion and Summary

6.1 Conclusion and Summary........................................................................................................ 87
Appendices
Table 1-8............................................................................................................................................... 89
Appendix A-E..................................................................................................................................... 97
Graph A-D.......................................................................................................................................... 104
Bibliography
Bibliography...................................................................................................................................... 1 08
Vita...................................................................................................................................................... 114
vi
Chapter One
Introduction
1.1 Tax Consequences of Using Derivatives (Topic of Interest)

In the past decade, the availability and variety o f financial instruments have grown
tremendously. One reason for this growth is the relation between using financial instruments and tax
minimization, given the differences in the taxation of debt, equity, futures, options and foreign
currency transactions in various forms. This thesis focuses on the ways in which derivatives affect
corporate tax planning and accounting. Tax planning and accounting are related because taxable
income is computed using an accounting method that is related to the method used for external
reporting through the clean surplus model, whose properties have only recently been examined
in the literature.
Derivative financial instruments can affect taxes in three main ways (Ferguson 1994):
1
1. C haracter: whether gains or losses from a derivative transaction are capital or ordinary. Capital
gains are preferred to ordinary income since capital gains are often taxed at a lower rate than
ordinary income and taxpayers can delay recognizing capital gains. In contrast, ordinary losses are
preferred to capital losses, because capital losses are deductible only against capital gains.
2. Tim ing: the timing o f recognition o f capital gains and losses and ordinary income and expenses.
This tax accounting question is important because of the time value of money. Taxpayers prefer to
accelerate deductions and defer recognition o f income, lowering the present value of taxes payable.
3. In ternational issues: In addition to the character and timing questions, international tax issues
are also raised by derivatives.
This thesis analyses only the character and timing tax issues, particularly as they are reflected
by the clean-surplus accounting system (Feltham and Ohlson 1995; Ohlson 1995) that is typically
used to compute corporate taxable income.
With respect to the tax timing issue, as Constantinides (1983) and Constantinides and
Ingersoll (1984) have shown, given that capital gains and losses are taxed only when realized,
optimal tax-trading behaviour in an environment o f fluctuating securities prices involves deferring
the realization o f capital gains indefinitely to avoid paying taxes thereon, but realizing capital losses
to offset any capital gains unavoidably realized. The ability to implement such a strategy conveys
to investors a valuable tax-timing option that can contribute significantly to the total value of an
investment position in a security.
Lewellen and Mauer (1988) argued that the existence o f tax-timing options has provided an
incentive for firms to have complex capital structures. Given two firms whose asset holdings and
operating cash flows are identical, but one o f which is levered and the other is not, fluctuations in
the total market value o f the unlevered firm will permit shareholders to exercise their tuning option
2
to take losses and defer gains in the manner described by Constantinides (1983, 1984).
Corresponding fluctuations in the market value o f the.levered firm, however, will present investors
in the aggregate with additional timing opportunities, as long as the prices o f the firm's constituent
securities do not always change in the same direction. Because debt and equity differ in duration,
seniority, and the like, it is likely that their prices might sometimes move in opposite directions.
Accordingly, the aggregate value of these tax-timing options for the investors of a firm will be
enhanced when the firm has multiple classes o f tradable securities outstanding. For that reason, the
inclusion o f debt as well as equity in a firms capital structure should raise the firms total market
value.
This study will extend the above point o f view by integrating derivatives into the capital
structure o f the firm, and show that the introduction of derivatives other than common stock and debt
into a firm's capital structure will result in aggregate tax-timing option values that will equal or
exceed those available when the same firm has only common stock and debt outstanding.
Furthermore, the introduction o f additional derivatives will strictly raise option values if the taxtrading opportunities for investors in the derivatives are not perfectly synchronous with those of
common stock and debt investors.
With respect to the tax character issue, under the U.S. Internal Revenue Code (IRC
Sec. 1211), net short-term capital losses and 50% o f net long-term capital losses are deducted from
ordinary income and may jointly reduce the taxable ordinary income by a maximum of $3,000 (until
1976,51,000). Unused losses are carried forward indefinitely. Short-term losses and long-term gains
incurred in the same year offset each other dollar for dollar, instead o f being taxed at their respective
rates. In Canada, today 3/4 o f capital gains are taxed, and 3/4 o f capital losses are deductible from
only capital gains (Thornton 1993). Capital gain or loss treatment results when two requirements are
3
met (IRC Sec. 1222):

(1) the gain or loss is from a "capital asset"; and
(2) the gain or loss is realized from a "sale or exchange" o f that asset.
A taxpayer's contractual rights and obligations can be terminated in many instances by
subsequent agreements to cancel an original contract, as well as by a transfer o f the contract to a
third party. Therefore, in the absence o f the corrective legislation, the "sale or exchange" requirement
could be met (to make a gain capital) or avoided (to make a loss ordinary) by using the complex
derivative instruments, whose capacity to replicate or interact with asset or liabilities makes it
possible to produce either ordinary gain (or loss) or capital gain (or loss) at the election o f the
taxpayers. Since the tax rates o f capital gains are less than the ordinary income, and the capital losses
are generally deductible only from capital gains, the tax m inim izin g strategies will be to realize
losses as ordinary losses and realize gains as capital gains. Hence, the distinct tax treatment between
ordinary income (or expenses) and capital gains (or losses) will provide the taxpayers with the taxcharacter options.
Under the clean surplus accounting system, based on the Feltham-Ohlson representation of
market value as a function o f book value plus the present value o f abnormal future earnings (Feltham
and Ohlson 1995, Ohlson 1995), we develop a tax-based market valuation model. It is shown that
firm market value can be expressed as the bottom line accounting data, i.e., the book value and the
abnormal earnings, as well as the tax data. The strategies o f exploiting tax-timing option value and
tax-character option value can save tax and thus enhance firm market value.
1.2 Contributions of the Thesis
The thesis makes three major contributions for the current research on tax
p l an n in g
using
financial instruments, and market valuation under corporate taxation. First, it extends the tax-timing
option model o f Lewellen and Mauer (1988) to incorporate other financial instruments, including
derivatives, besides debt and equity. The model demonstrates that using other financial instruments
including derivatives will increase this tax-timing option value, and therefore enhance the firms
market value. Second, the thesis extends the model further to analyse the tax-character option. It
shows that the taxpayers will realize losses as ordinary, not capital, given the tax advantage o f
ordinary losses over capital losses. Finally, the thesis explores tax effect on firm market value under
clean surplus accounting. It extends the Feltham-Ohlson market valuation model (1995) to
incorporate taxes, and sets up a theoretical framework for the analysis o f the tax effects on firm
market value.
1.3 Organization of the Thesis

The thesis is organized as follows. Chapter 2 reviews the relevant literature. This includes
the literature related to the tax-timing issue, the literature related to the tax-character issue, and the
literature related to tax effect on firm market value under clean surplus accounting. Chapter 3 derives
a theoretical framework based on Lewellen and Mauer (1988), proves two propositions and provides
three examples to show how firms can use derivatives to exploit tax-timing and tax-character option
value. The relationship between using derivatives and exploiting tax-timing option value is tested
empirically. In chapter 4, the effect of corporate taxation on firm valuation under clean surplus
accounting is analysed. First, the relation between firm market value and accounting data is studied
under corporate taxation, which leads to the tax-based market valuation model. Second, under the
tax-based market valuation framework, we study the accounting implications of one o f the taxtrading strategy, i.e., exploiting tax-timing option value. Two extensions are made. Then, the
accounting implication o f another tax-trading strategy, i.e., exploiting tax-character option value, is
studied. Finally, the conclusion and summary are provided in chapter 5.
Chapter Two
Literature Review
2.1 Literature Related to Tax-timing Issues
2.1.1 Using Derivatives Poses Challenges for the Tax System
The increasing use of financial products in recent years has drawn more attention to the tax
issues stemming from their use. Ferguson (1994) argues that, in a tax system that depends largely
on categorization and that inevitably involves some irrationality in constructing the categories, there
can be no seamless set o f mles for derivatives. Based on categorization, the tax system differentiates
between capital gains and ordinary income; it does not generally impose mark-to-market accounting
rules, but relies instead on a realization rule for property dispositions and an accrual rule for periodic
income and expense items. The flexibility and transmutational qualities o f derivatives that make
these instruments useful for managing risk in the business world also make it difficult to pigeonhole
the instruments into the various standard categories comprising the tax system.
Ferguson provides an example o f equity swap. An equity swap is roughly equivalent to a
series o f stock forward contracts, and the tax treatment should be similar. The treatment o f forward
contract arrangement is based on realization, and thus the equity swap should not incur current
recognition o f gain or loss. However, the nonrecognition rule is challenged in instances where the
maturity o f an equity swap arrangement is extended to a period of, say, 10 years, 20 years or longer.
He concludes that
Development of the tax rules for derivatives has proceeded with an implicit recognition
of the fact that there cannot be a fully coherent set of rules for derivatives within an
overall tax system that is somewhat incoherent. So long as we have an income tax
system that distinguishes between capital gain or loss and ordinary income or expense,
that does not require universal mark-to-market accounting, and that does not fully
integrate corporate and shareholder taxes, there will be difficult categorization
problems (Ferguson 1994).
Evan (1992), Shuldiner (1992), and Scarborough (1994) recognize that the realization
doctrine poses problems for the tax system. The realization doctrine creates deferral opportunities,
and taxpayers holding derivatives may benefit from these opportunities. This realization doctrine
app lies generally to assets with contingent, rather than fixed, returns, like shares o f stock, speculative
contracts, forward contracts, and options to buy and sell assets. Because taxpayers can delay the
payment o f taxes on gains until they are eventually realized, the effective tax rate for those gains is
reduced. Consequently, the realization doctrine results in different effective tax rates imposed on
various assets based on their deferral period. In addition, the realization doctrine provides taxpayers
with opportunities to recognize artificial losses, i.e., losses exceed the economic losses which have
actually occurred. Taxpayers may artificially lower their taxable income by selectively choosing to
realize losses on depreciated property, while simultaneously delaying the realization o f gains on
property which has appreciated (referred to as cherry picking).

Freeman and Lipton (1994) argue that the disparate tax treatment o f debt, stock, options,
swaps, forwards, futures, commodities, and foreign currency transactions makes it difficult for the
tax system to deal with the financial instruments, which are not easily categorized, or which are
synthesized or replicated by combining or meshing other financial instruments that, treated
separately, would be subject to a different set o f tax rules.
Wolfson (1993) argues that a new challenge faces both the tax and financial reporting
systems due to the explosion o f new derivative securities being used in the marketplace; this new
trend may force fundamental changes in tax and accounting rules.
2.1.2 Theoretical Work Involving Tax-timing Options

Constantinides and Scholes (1980) indicate that with a tax on only realized capital gains,
investors would rationally realize capital losses and defer capital gains. Call options and commodity
futures contracts can be used to produce a capital loss in one tax year and an equal capital gain in
the next tax year, hence deferring capital gains from one period to the next period. Assuming the
proportional stock price change P /P t_t follows a binomial process, it is shown that using two call
options (writing a call and buying a call option) on stock in the hedge, investors can, with zero net
cash flows at each date t=0,1,2, realize a capital loss at date t= l and an equal capital gain at date t=2.
However, transactions costs, the distinction between the deduction limitations o f short term and long
term capital gains and losses, and the differing short term and long term tax rates complicate the
investors optimal tax trading policy.
Constantinides (1983) examines the effect o f the capital gains tax on investors optimal
consumption and investment decisions and on equilibrium asset prices. Particularly, he considers
9
the facts that capital gains and losses on stock are taxed only when the investor sells the stock, not
when market value changes. Owning the stock thus confers on the investor a timing option that
enables him to realize capital losses immediately while deferring capital gains, thereby reducing the
present value o f the stream o f tax payments on capital gains net of capital losses. The paper proves
that the optimal liquidation policy for the shareholders is to realize losses immediately and defer
gains until the event of a forced liquidation, i.e., until the investors death, or until an exogenous
event beyond his control forces him to sell the asset such as, extraordinary and nonrecurrent needs
to speculate, rebalance the portfolio, or consume the proceeds. The price o f the tax-timing option,
which is defined as the wasted fraction o f a dollar invested in stock, if the investor fails to take
advantage o f this timing option and realize capital losses whenever they occur, consists of a
substantial fraction o f the bundle of benefits associated with stock ownership. He argues that the
price o f this tax-timing option is increasing in the stock variance and dividend yield and is
decreasing in the probability o f forced liquidation.
Constantinides and Ingersoll, Jr. (1984) focus on how optimal trading affects bond prices.
They show that tax considerations govern bondholders optimal trading strategies, i.e., capital loss
realization; capital gains deferral; change o f the long term holding position to short term by selling
and repurchasing the bond; and realization o f future losses short term. These optimal strategies are
quite different from buy-and-hold and continuous-realization policies; therefore, the bond prices set
by the marginal investor following the optimal trading policy are different from those under a buyand-hold or continuous-realization policy. They confirm that the tax-timing option is an important
fraction o f the bond price, and the assumption that bondholders follow either a buy-and-hold or a
continuous realization policy, rather than the optimal trading policy may seriously bias the bond
prices, the econometric estimation of the yield curve and the implied tax bracket of the marginal
10
bondholders.
In their paper, Constantinides and Ingersoll, Jr. present the buy-and-hold policy as the
benchmark in which there are no price effects induced by tax trading. They classify four tax
scenarios with respect to different marginal investors and different short term and long term tax
rates. Under these four tax scenarios, the authors compare bond prices, tax timing option, and yield
curve o f the bondholders who follow the benchmark of a buy-and-hold policy with those o f the
optimal policies. They also measure the value o f the tax timing option. They find that for the higher
variance process, the timing option contributes a significant portion of the bonds value as measured
against either buy-and-hold benchmark and the continuous-realization benchmark. For the low
variance process, the timing option remains important except in the case when large capital losses
are expected and the continuous realization benchmark is employed. Therefore the effect o f tax
trading on bond prices cannot be ignored.
Constantinides and Ingersoll, Jr. also simulate Treasury bond prices that would be established
by the marginal investor following the optimal trading policy. It is shown that the tax-timing option,
defined as the difference between the bond prices under the optimal and those under the buy-andhold policies, is a percentage o f the bond prices, and varies widely for different coupon rates,
maturities, and tax rates. The tax-timing option retains a large fraction of its value even with sizable
transaction costs, such as a bid-ask spread or other costs o f trading.
With respect to the yield curve and the implied tax rates, the authors argue that if the
marginal investors follow the optimal trading policies, estimates o f the yield curve and the implied
tax rates obtained by the buy-and-hold policy may be biased.
McDonald (1986) shows that corporate income taxes can affect firms futures hedging
strategy under two conditions: when gains and losses on futures and the underlying assets are not
11
realized at the same time (thus, the tax-timing option applies); and when futures and the underlying
assets are not taxed at the same rates (thus, the tax-character option applies). The hedge ratio
computed including the tax effect is different from that computed by ignoring taxes. McDonald
further shows that whichever hedging ratio the firm selects, it is always optimal to sell and realize
the losses, but not to sell and realize gains on the underlying asset. This tax-timing option produces
a positive profit, since it is obtained at the expense o f the government. McDonald provides two
examples to show that the firm can profit by exploiting the tax-timing option. In the first example,
the firm can make both borrowing and lending commitments simultaneously. When the interest rate
changes, one commitment incurs losses, the other receives gains. The firm will realize the losses
while holding the gains. In this case, the tax-timing option is always positive. The second example
involves two loan commitments with different futures hedging ratios. By selling both loans when
losses are incurred, while not selling in the event o f gains, positive tax-timing option value is also
assured.
Lewellen and Mauer (1988) extend the work by Constantinides (1983, 1984) and
Constantinides and Ingersoll (1984) and indicate that among the elements o f value reflected in the
prices o f corporate securities are the tax-timing options associated with the opportunities for the
investors to tax-manage their portfolios by deferring gains and realizing losses. One rationale for
complex capital structures is that when more than one class o f such securities is issued, the taxtrading opportunities available to the owners o f the firms securities will, in general, increase in
value. For example, we can contrast the circumstances o f investors who own the securities of two
firms. These two firms have the same asset holdings and operating cash flows, but one is levered and
the other is not. Fluctuations in the total market value o f the unlevered firm will permit shareholders
to exercise their timing option to take losses and defer gains in the manner described by
12
Constantinides (1983, 1984) and Constantinides and Ingersoll (1984). Corresponding fluctuations
in the market value o f the levered firm, however, will present the investors in the aggregate with
additional tax-timing opportunities, as long as the prices of the firms constituent securities do not
always change in the same direction. Thus, a given increase in total firm value may be associated
with an increase in the market value o f equity that is partially offset by a concurrent drop in the value
ofdebt. Shareholders in that situation will optimally defer the realization o f gains, while bondholders
will be able to take their losses for tax purposes. If the same net change in value occurred for the
unlevered firm, the latter loss-taking opportunities would not be available. In fact, a firms bond and
equity prices might not often move in the same direction. Accordingly, the value of the tax-timing
options on the separate securities that comprise the portfolio o f multiple claims on a levered firm
should exceed the value of the tax-timing option on the composite portfolio that the equity claim
to the same firm, if unlevered. The enhanced tax-timing option values should, in turn, cause the
levered firm to command a higher aggregate market value.
In Security holder Taxes and Corporate Restructures (1990), Mauer and Lewellen show
that during the 1980s, there were a series o f corporate restructures, which included mergers and
acquisitions, recapitaliztions, leverage buyouts, spin-offs and divestitures. The literature ascribes
many motives for these restructuring events. Mauer and Lewellen add to the previous literature by
suggesting that such corporate restructuring may also be motivated by tax considerations. The
authors argue that one factor contributing to the positive abnormal returns associated with corporate
spin-offs and divestitures during the decade o f the 1980s is the tax-timing option effect. Assume the
firm restructures itself by spinning off its businesses into an independent corporation and by
distributing the common stock o f the new firm to its existing shareholders. Also assume there is no
change in the operating profitability of each business after the restructuring. Investors will then
13
experience capital gains and losses from their respective holdings in the tw o corporations. Even
though the change in shareholder wealth will continue to match what would haive occurred if the firm
had remained a single entity, investors can now trade separately on movemenrts in the market values
o f each company. The advantage of being able to do so lies in the exipanded opportunities
shareholders will have to realize losses for tax purposes when the market values of the two firms
change in opposite directions. Hence, even if a corporate spin-off results in mo improvement in the
profitability o f either the remaining or the spin-off businesses, it will result :in an improvement in
security holder tax-trading opportunities as long as the market values of tine components o f the
disassembled asset can move nonsynchronously. In turn, that improvement w ill raise the total value
o f the tax-timing options available to investors and thereby cause the aggregate values of the
remaining and spun-off assets to exceed their value when located in a single com bined corporation.
Mauer and Lewellen further find that the more diverse the spun-off and rem aining assets of the
original company, the larger the tax-timing option gain and the greater should fee the valuation effect
o f a spin-off; the empirical evidence is consistent with this finding.
The authors apply a similar argument to divestitures; however, a portion o f the tax-timing
benefits is lost when the divested assets transfer from an existing firm to another, rather than being
reconstituted as a new firm. Hence, the abnormal returns for spin-offs generaJly exceed the returns
for divestitures. This finding is consistent with the evidence that the positive; abnormal returns for
the parent company on and around the announcement dates o f spin-offs are i n the range o f 2 - 4%,
while the corresponding abnormal seller-firm returns are only in the range o f 0.5 - 1%.
2.1.3 Empirical Work Involving Tax-timing Options

Litzenberger and Rolfo (1984) examine a set o f three government Ibonds with the same
14
maturity date. They find that the taxation o f capital gains on the basis o f realization has a significant
impact on relative prices. Their empirical results support the tax-timing option effect.
Lamoureux and Poon (1987) analyse the market reaction to stock splits. They confirm
Constantinides.argument that security volatility is desirable to the extent that it provides the
security holders with the opportunity to realize losses short term or capital gains long term in order
to reestablish short term status. They demonstrate that the positive abnormal returns associated with
stock splits can be explained directly by the gains in tax-timing option values attributable to the
increased share price volatility resulting from the split. They argue that the announcement o f a split
sets o ff a series of events. Subsequent to the split ex-day, the daily number o f transactions along with
the raw volume of shares traded tends to increase. This increase in volume results in an increase in
the noisiness or volatility o f the securitys price series, and hence raises the tax-option value o f the
stock.
Conroy and Rendelman (1987) conduct an empirical test o f the tax-option hypothesis and
conclude that the tax-option effect exists. A similar test conducted by Prisman et al. (1994) supports
the existence o f the tax-option effect in the Canadian market.
Bossaerts and Dammon (1989) use the generalized method o f moments procedure to test
whether the tax effect on equilibrium asset prices exists. They find that, when investors have the
option to optimally time the realization o f their capital gains and losses, the tax-option alters both
the magnitude and timing o f equity returns, compared to those in a tax-free model. Using monthly
consumption and return data over the period from March 1959 to December 1986, the results provide
reliable evidence of tax effects on the relative pricing o f common stocks and treasury bills.
Jordan and Jordan (1991) use Treasury bond triplets to investigate the theoretical and
empirical influence o f tax strategies on treasury prices. A Treasury triplet is a set o f three Treasury
15
issues which have the same maturity date but different coupon rates. For such triplets, the pretax
cash flows on any one o f the bonds can be replicated by a portfolio of the other two bonds. In a
ffictionless market, there must be a linear relation among the prices o f Treasury triplets, or a riskless
arbitrage opportunity exists. Under taxation, transaction costs, and other market frictions, convexity
in the relation among triplet bond prices will be generated. Jordan and Jordan find that Treasury
triplets are convex in their coupons. However, the degree o f convexity is quite small and is easily
obscured by bid-ask spreads and other market frictions.
Brickley et al. (1991) examine the discounts on closed-end investment funds in light o f the
tax-timing theory presented by Constantinides (1983,1984). The tax-timing theory states that the
value o f an assets tax-timing option is positively related to the variance o f the assets before-tax rate
o f return. The empirical analysis uses 57 annual reports o f 14 investment companies over the period
1969-78. It shows that the discounts o f the funds are significantly and positively related to the
average variance o f the constituent securities rate o f return. Even though alternative interpretations
are possible, the time-series evidence does support the tax-timing theory o f the discounts on closedend funds.
Ehrhardt et al. (1995) conduct the empirical tests on a pooled cross-section and time-series
sample o f U.S. treasury bonds from 1976 through 1985. They find that the tax option effect causes
a deviation in the price o f a bond from its present value. The regression of bond prices on after-tax
bond payments is shown to be capable o f identifying tax effects in U.S. treasury bond prices.
Chang et al. (1995) argue that a long-term debt maturity strategy generates higher tax-timing
option values than rolling over a sequence of short-term bonds. This proposition is consistent with
the theory provided by Constantinides (1983,1984) that the tax-timing option value increases with
the maturity o f the debt contract since long-term bond prices are more volatile. Two extended
16
predictions are described: the firm will lengthen debt maturity as interest rate volatility increases;
and the firm will lengthen debt maturity as the slope o f the term structure increases. An empirical
work o f the debt maturity structure decision o f 328 firms over the period o f 1980-1989 supports
these predictions.
2.1.4 Summary
In summary, theoretical and empirical work has analysed tax-timing option issues since the
1980s. The literature shows that the tax-timing option is an important influence on security prices.
Tt also shows that firms will exploit the tax-timing option value in order to enhance their market
value. The development and the increasing use o f derivatives in recent years has provided taxpayers
with convenient ways to exploit this tax-timing option value.
2.2 Literature Related to Tax-character Issues

Derivatives also pose character problems for the tax system. One issue is whether the gain
or loss from a derivative transaction is capital or ordinary. The relative advantages and disadvantages
have changed over time. For example, until 1972, capital gains were not taxed at all in Canada. From
1972 until 1987, lA o f capital gains were taxed; in 1988 and 1989, 2/3 o f capital gains were taxed.
Today 3/4 o f capital gains are taxed, and 3/4 o f capital losses are deductible from taxable capital
gains (Thornton 1993). In the U.S., however, 100% capital gains are taxed, and up to $3,000
ordinary income can be offset by capital losses. Hence capital gains has a tax rate preference over
ordinary income in Canada. Taxpayers prefer ordinary losses to capital losses because capital losses
are deductible only against capital gains, and from no other type o f income.
17
In general, Ferguson (1994) argues that a capital gain or loss results under two conditions:
when the gain or loss is from a capital asset; and when the gain or loss is realized from a sale or
exchange o f that capital asset. A capital asset is generally referred as an asset that is both acquired
and used to provide the owner with a long-term and enduring benefit. Therefore, to qualify as capital
assets, assets must be disposed o f irregularly and infrequently. However, with the ability to replicate
or interact with assets or liabilities using derivatives, it is not difficult for taxpayers to meet the two
requirements to make gains capital, while avoiding the two requirements to make losses ordinary.
Ferguson provides an example. An investor buys a two-year note calling for quarterly
payments o f interest at a fixed rate. The lender also enters into a series of short Eurodollar futures
contracts (A short Eurodollar futures contract is the equivalent of an agreement to borrow funds for
a three-month term, commencing on the delivery date o f the futures contract, at an interest rate
specified by the parties to the contract.) having delivery dates corresponding to the quarterly interest
payment dates prior to maturity. If the LIBOR rate increases as the delivery date approaches, the
short position will be closed at a gain because the lender can borrow funds at an interest rate below
the market rate. The gains on the Eurodollar futures contracts adjust upward the note interest
payments in the subsequent contract. On the other hand, if the LIBOR rate decreases, a loss on the
Eurodollar futures contracts adjust downward the renewed note interest payments. Therefore, the
series o f Eurodollar futures contracts hedge to convert the lenders interest income from fixed to
variable. If the lender is an investor holding the note as a capital asset, the Eurodollar futures
contracts will give rise to capital gains and losses. Disposition o f the note will produce capital gains
and losses while the interest income received is ordinary. Under these circumstances, a hedge of the
ordinary interest income will also hedge, to some extent, the capital asset itself. A mismatch is
incurred when a taxpayer, who entered into a short interest rate hedge effectively to convert the
18
fixed-rate debt instrument into a variable-rate debt instrument, claims an ordinary hedging loss on
disposing o f the hedge in a falling interest rate environment, and at the same time claims a capital
gain on disposition o f the debt instrument itself.
Ferguson also argues that another type o f character issue is whether payments with respect
to a financial instrument are categorized as dividends on stock, as opposed to interest or other types
o f payments. The corporate taxpayer generally seeks to classify the instrument as debt in order to
obtain tax advantages; the taxpayer can then deduct interest and avoid the double taxation on
corporate profit, while classifying the same instrument as equity for accounting, regulatory and other
purposes.
Freeman et al.(1994) argue that the development o f the tax rules dealing with the character
issue (i.e., whether gains and losses from a derivative transaction is capital or ordinary) has been,
to a significant extent, a response to perceived taxpayer manipulations. Thus, there does not exist
a cohent and comprehensive treatment o f derivatives in the tax system. They find that, because of
the increased use of derivatives, it has become increasingly difficult to characterize an instrument
as debt or equity. Furthermore, characterization no longer involves just a debt/equity categorization;
it also includes treating the payment as option premium, swap premium, prepayment o f a forward
contract, cap or floor premium, and so on. The issuers objectives may extend to obtaining a
favourable accounting treatment or a better rating from a credit agency, to meet a regulatory
restriction; and to hedge price, interest-rate or exchange-rate risks. Without a clear analytical
framework for determining the characterization o f an instrument as debt or equity, financial
instruments can be designed to contain a combination o f debt and equity features to be treated as
debt for tax purposes, but as equity for regulatory, rating agency or accounting reporting purposes.
In summary, derivatives foment tax-character issues. However, existing studies do not
19
provide conclusive theoretical or empirical research on how the tax-character option affects
securities prices and firm market value, or on how the firm will exploit this tax-character option.
2.3 Literature Related to the Effect of Taxes on Firm Valuation under Clean
Surplus Accounting
2.3.1 Feltham-Ohlson Model Relating Firm Value to Accounting Data in a Neoclassical Setting
A series o f papers by Feltham and Ohlson analyse the measurement perspective on
accounting. The models relate firm market value to its accounting data, e.g., earnings, book values
and dividends, under clean surplus relation.
Ohlson (1995) develops and analyses a model relating market value to current and future
accounting data: earnings, book values, and dividends. The model rests on two owners equity
accounting constructs: the clean surplus relation and the assumption that dividends reduce current
book value but leave current earnings unchanged. The model shows that the firms market value is
a weighted average of capitalized current earnings (adjusted for dividends) and current book value.
Combined with a simple linear model specifying the information dynamics, firm market value equals
to the book value adjusted for (a) the current profitability as measured by abnormal earnings, and
(b) other information that modifies the predictions o f future profitability. It concludes that both the
balance sheet and the income statement contribute to the measurement o f the firms market value.
The relevance o f this work for tax planning comes from the fact that companies compute taxable
income using a clean-surplus accounting model that is a transformation o f the clean surplus
accounting method used for financial reporting to shareholders.
Feltham and Ohlson (1995) extend earlier work on the relations between firm value and
20
accounting data by dividing the firms activities into financial and operating activities, and analyse
how firm market value is related to its accounting data concerning both operating and financial
activities. The analysis demonstrates that, under the clean surplus relation, the market value can be
expressed as (a) the book value plus the net present value of expected future abnormal (operating)
earnings or (b) the book value o f financial assets plus the present value o f expected future cash flows
from operations. The expected future information such as the expected future performance from
operation, together with the current accounting data, is enough to determine firm market value.
Feltham and Ohlson conclude that the connection between accounting numbers and the
firms market value remains valid for all accounting principles satisfying clean surplus relation. This
conclusion permits the introduction o f an accounting framework in valuation without specifying
accounting principles.
Feltham and Ohlson examine a set o f linear information dynamics in w hich the book value
o f operating assets and abnormal operating earnings fo r one period, together with other information,
are linked to these variables for the next period. The linear information dynamic model incorporates
the persistence o f abnormal earnings, the growth in operating assets, and the conservatism o f the
accounting principles used. A market valuation is derived in which market value is a function of
current book value plus a multiple o f current abnormal earnings, a multiple o f current book value
o f operating assets, and an adjustment for other information. Under the linear information dynamics
and the market valuation function, certain issues are analysed: price/eamings relations, properties
o f the earnings dynamics, cash earnings versus accrual earnings, and unbiased accounting versus
conservative accounting.
Penman (1992) uses the same market value function and argues that, in the market value
function, earnings aggregate in a value sense. The firm valuation does not involve predicting
21
earnings next year, the following year, and so on, but the total dollar earnings that a firm will deliver
to the horizon. Thus, the issue o f accounting principles over the forecast horizon and the possibility
o f manipulation o f income using accounting principles are not o f concern if they merely result in
timing differences. If you play with the income in one period, he says, (by using accelerated
depreciation, for example), the system plays catch up against you, as long as clean-surplus
accounting is maintained. Thus, in an important sense, the choice o f accounting methods is
irrelevant in the absence o f taxation, as long as the firm follows clean surplus accounting.
2.3.2 With Corporate Taxation, Tax-saving Strategies Affect Firm Market Value
Feltham and Ohlson (1995) show that the firms m arket value is the sum of the firms
current book value, and the net present value of expected future abnormal earnings. This conclusion
pertains all clean surplus accounting principles. Their model ignores corporate taxation. However,
there are several theoretical and empirical studies relating firm market value to accounting data under
corporate taxation.
Guenther and Sansing (2000) provide a theoretical framework relating firm market value to
operating data under corporate taxation. The model shows that, under corporate taxation, share price
depends on the present value o f expected future cash flow from operation, net of tax.
Biddle and Lindahl (1932) use cross-sectional regressions to examine the market reaction for
approximately 300 NYSE firms that adopt last in first out (LIFO) in the period of 1973-1980. They
regress firm excess returns for 15 months on abnormal earnings performance, measured by the
unexpected earnings and the tax savings from LIFO adoption. The coefficients on the tax saving and
abnormal earnings performance variables are positive and significant. This observation leads to the
conclusion that the market reacts positively to the cash-flow implications o f LIFO adoption, and
22
investors reactions to LIFO adoption depend positively on the expected present values of tax-related
cash-flow savings.
Other studies examined the responses o f firms to the U.S. Tax Reform Act o f 1986. A part
o f this act, Alternative Minimum Tax (AMT) explicitly links corporate taxation to financial book
income and seeks to eliminate highly publicized instances in which corporations with substantial
book income pays no tax. It requires the inclusion o f a variant o f financial accounting income (AMT
book) in the AMT income tax base for 1987 through 1989. The AMT created an incentive to shift
income to 1986 from 1987 to avoid the 20% tax rate on alternative m inim um taxable income and
an effective marginal rate o f 10% on AMT book imposition. On the other hand, the decrease in the
regular tax rate from 46% as o f June 1987 to 34% as o f June 1988 in monthly steps o f one
percentage point created an incentive to shift income forward.
Fields and Samson (1987) find that, for the closely-held corporate/owner-manager situation,
income splitting can be used to pay less total tax. They use a (computer) model which calculates the
total tax (a combination o f individual income tax, payroll tax, and corporate income tax) for the.
combined individual-corporate tax entity. Fields and Samson show that the tax changes made by the
1986 Tax Reform Act (TRA) affected the total tax paid by the closely held corporation and its
owner. The new tax rates regulated by the 1986 TRA reduced the overall tax paid and also shifted
the optimal payment points. This shift caused larger amounts o f salary to be paid in 1987 and 1988
than were optimal in 1986.
Dhaliwal and Wang (1992) examined the effect o f the book income adjustment provision in
the 1986 Tax Reform Act, the alternative minimum tax, on financial accounting practices. The use
o f book income to determine part o f the income tax base provides incentives for firms to manipulate
their financial reporting in order to reduce the book income adjustment and the AMT burden. This
23
adjustment can be accomplished by changes in accounting policies and investment decisions, such
as lease-versus-buy. Their empirical results suggest that firms that are likely to be affected by the
book income adjustment may shift timing and permanent differences in accounting income across
years to reduce the impact o f the AMT.
Scholes et al. (1992) investigate whether and how firms shift income over time in response
to the declining tax rate, caused by the 1986 Tax Reform Act. The reduction in statutory tax rates
from 46% to 34% by the middle o f 1988 gave firms an incentive to defer income in 1986 and 1987.
Firms can defer income in anticipation o f these tax rates declines, for example, by postponing sales,
accelerating research and development expenditures, accelerating advertising
c a m p a ig n s ,
and
accelerating pension contributions. The results show that sales were shifted from the last quarter of
one year into the first quarter o f the next year during 1986-88. Therefore, firms deferred revenue
recognition and/or accelerated expense recognition in anticipation o f the declining tax rates.
Boynton et al. (1992) use financial data from Compustat files and tax data from confidential
research files of U.S. corporate tax returns prepared by the Statistics o f Income division o f the
Internal Revenue Service. Firms that were subject to the AMT in 1987, but were unable to reduce
their AMT exposure through the use o f net operating losses and foreign tax credits, managed their
1987 earnings by taking unusual income-decreasing discretionary accruals. Other tax policymakers
and practitioners also expressed concern that the AMT book provision would lead firms to manage
their earnings in order to reduce their potential AMT liabilities.
Gramlich (1991) reports that firms likely to be affected by the AMT made income-decreasing
accruals in 1987, and income-increasing accruals in 1986, relative to a control group. Choi et al.
(1991) extend Gramlich by increasing sample size and extending the data through 1988. They find
that the use o f 1983-85 for the base period resulted in a finding of income-decreasing accruals for
24
both 1986 and 1987 for affected firms, relative to unaffected firms. They also find that the evidence
o f earnings management is strongest in the areas o f inventories and accounts payable, and that other
current and noncurrent accruals are largely unaffected.
Manzon (1992) uses cross-sectional data from 1983-1987 to estimate the effects of AMT
exposure on discretionary accruals related to long-term assets, including depreciation charges. AMT
exposure is identified by searching financial statement footnotes. His results support the hypothesis
that firms managed earnings in 1987 to save taxes, and that firms without net operating losses were
more likely to do so.
Finally, Maydew (1997) examines intertemporal income shifting by firms to save taxes
following the 1986 TRA. Firms shifted the recognition o f revenues and expenses across years to
increase their net operating loss (NOL) carrybacks, and get tax refunds based on a higher tax rate
(i.e., the rate that existed before the 1986 TRA). The methods to shift income included deferring the
recognition o f sales and nonrecurring gains, accelerating recognition o f discretionary expenses and
nonrecurring losses (for example, selling operating assets which had declined in value), etc. The
paper classifies firms into a treatment group, which has NOL carrybacks during a period
immediately after the 1986 TRA was enacted, and a control group, which has NOL carrybacks
outside the period. It is shown that during 1986-1991, treatment firms withNOL carrybacks deferred
operating income, recogn izin g more expenses and nonrecurring losses to increase their NOL
carrybacks to pre-1986 tax years. However, tax and nontax costs and benefits may affect their shift
activities. Firms with large amounts o f investment tax credits in prior years shifted less income, as
did firms with higher leverage.
25
2.3.3 Summary
Feltham and Ohlson provide a model to relate firm market value to its accounting data, such
as book values, earnings, and dividends, in a neoclassical setting. They and other find that, under the
neoclassical setting, a firms market value can be represented in three types: (1) discounted future
dividend, (2) a financial technique or discounted cash flow or (3) book value plus discounted
abnormal earnings. Empirical research suggests that corporate taxes affect firms market value. This
finding motivates an extension o f the Feltham-Ohlson model by incorporating tax in Chapter 4.
2.4 Conclusion
The use o f derivative instruments in recent years poses challenges for both tax systems and
financial accounting systems. The literature does examine the effects o f derivatives on taxes and the
effects o f tax on accounting choice. However, there is no analysis to date o f the effects o f derivatives
on corporate taxation, and the effects o f corporate taxation on firm market value under clean-surplus
accounting. A major goal of this thesis is to analyse the effect o f derivatives on corporate taxation,
and the corporate taxation, based on a clean-surplus accounting system, on firm market value.
26
Chapter Three
Tax-Timing Option and Tax-Character Option
Value Using Derivatives
3.1 Introduction
[n this chapter, a theoretical framework is derived based on the Lewellen and Mauer (1988)
analysis. While Lewellen and Mauer study the tax-timing option only for unlevered and levered
firms, we extend the work by adding other financial instruments and by studying both tax-timing and
tax-character options. Two propositions under individual tax are presented and proved. The first
proposition indicates that the value o f the tax-timing option on the shares o f a firm using equity and
debt is at least as good as that using equity solely. Furthermore, the use o f additional securities,
including derivative instruments, can raise this tax-timing option value; it can raise this tax-timing
27
option value strictly if the tax-trading opportunities for the investors in these additional securities
are not perfectly synchronous with those o f common stockholders. This section also proposes that
taxpayers will claim their losses as ordinary" rather than capital. An illustrative example is described.
We further examine firms tax planning using derivatives under corporate taxation, showing that by
using derivatives, firms can minimize taxes b y exploiting tax-timing and tax-character options. Three
examples and empirical tests are presented to support this argument.
3.2 Valuation Framework

Following Lewellen and Mauer (19S8), the analysis adopts a multi-period state-preference
model. There are three assumptions:
(1) The firm's investment strategies are provided - in particular, although specific future
investment decisions are not known, the rules governing those decisions are known and
consistent with the maximization o f security holder wealth.
(2) Capital markets are perfect, w ith no transactions costs, infdrmational asymmetries, or
costs associated with bankruptcy.
(3) There is no taxation at either the corporate or personal level.
Using these assumptions, we will show that firms' total values are equal, whether or not they
use other classes o f securities, including derivatives, besides equity and debt. This is just an example
o f the Modigliani-Miller (M-M) theorem. Assumption (3) will be relaxed later, and we will show
that the tax-timing and tax-character options will increase the firms' values if they use additional
financial instruments.
The time t market value o f the unlevered firm can be expressed as (Lewellen and Mauer
28
1988):
m = f n t + i , Q ) d P (t+ 1, 0 )
(l)
0: the states o f nature that can occur at time t+l

P(t+l,0): the probability distribution o f corresponding state prices
V (t+l,0): the random time t+l state 0 value o f the firm
Following Lewellen and Mauer (1988), we assume no dividend payment during the interval
t, t+ l. We argue that the recognition of only one tax-trading strategy at t+1 suffices to establish the
propositions. Thus we take V ( t + 1,#) as exogenously given and not dependent on future taxtrading benefits. We simplify the notation by dropping the time subscripts. Equation (1) becomes:
F=A[F(0)]
(2)
where A is the time-state-price integration operator, which is linear and positive.

The value o f the debt and equity claims on an otherwise identical but levered firm can be
similarly obtained. Let
R = interest payment promised to bondholders at time t+1
D(0) = market value o f the firm's debt in state 0 at time t+1
S(0) = market value o f the firm's equity in state 0 at time t+1
Given the three main assumptions above, it is known that levered and unlevered firm total market
values will be equal (Fama, 1978). That is:
S(0)+D(0)=F(0)
(3)
29
It is important to specify how these values are divided among stockholders and debtholders
in the various states that do or do not involve a default on debt obligation at time t+1 because the
distributions o f S(0) and D(0) reflect investors opportunities to exploit tax-trading strategies in the
two separate securities at time t+1. Debt default occurs in states when (Geske 1977)
R zS( 0)
(4)
that is, the interest payment is no less than the equity value. Substituting (3) into (4), we obtain the
alternative expression o f the default condition:
[S + D (e )]^ (0 )
(5)
Hence, the bondholders' claim on the firm in state 0 at time t+1 is:
Y rf(0) =m in[F(0)^ +>(0)]
(6)
The stockholders' claim will be:

Y S(Q) =max{V(Q)-[R +Z>(0)],O} =max&(0) -R,Q\
(7)
The claim of the stockholders on the firm can be viewed as either the payoff o f a call option on V(0)
with exercise price R+D(0), or that o f a call option on S(0) with exercise price R.
Using the time-state-price integration operator, the time t values o f equity and debt are:
D=A[rrf(0)]
(8)
S=A(r'(0)]
(9)
30
Then, similar to Lewellen and Mauer (1988), we have:

5 ^ D = A [r,( 0 ) + r </(0)]
=A(max(7(0) -& ->()]0] +m in[F(0), +D(0)]}
=A(r(0) -m in[r(0)^+)(0)]
-min[F(0)^+D(0)]}
(lU)
=A[F(0)]
=V
The total market values of the levered and unlevered firms are equal at time t.
Finally, we add other financial instruments, including derivatives, subordinate to debt. Let
Q: payment promised to the additional security holder, e.g., the interest payment o f a swap,
or convertible bond, the dividends of preferred stock, and the like.
F(0): market value o f the firm's additional financial instruments in state 0 at time t+1.
The debt default also occurs under condition (4). However, the claim o f the additional financial
instrument on the firm at time t+1 in state 0 is:
r/(0)=max{O^nin[F(0)->(0)-^fi+/r(0)]J
(11)
The equity holders' claim will be:
F'C) =max{F(0) -[ +Z>(0)] ~[0+^l9)],O}

=F(0)-min{F(0),|tt+>(0)] +[fi+Fl(0)]}
( 12)
Using the linear operator, we have:

S+F+D = A
(l3 )
In appendix A, it is shown thatS+F+D=V (note S and D may not be the same as those for
the levered firm without other financial instruments). The total market values are equal whether the
31
financial instruments are used or not. This no-value-change conclusion is obtained under the three
unrealistic assumptions. In the next section, we will drop the last assumption - no tax assumption.
3.3 Security Holder Tax-timing Option

Suppose we revise assumption (3) and stipulate that there is personal taxation to the
investors in corporate securities. To simplify the model, assume the tax rate to the investors is
uniform, at a rate o f r e (0,1), which is state independent, and there are no corporate taxes. Investor
tax-trading opportunities occur only at time t+1.
If the equity holders in the unlevered firm follow an optimal trading policy, they will realize
their losses to take the associated tax deductions when V(0)<V, but will not trade to realize a gain
when V(0) ^ V. Thus, the aggregate equity tax-timing option payoff is:
(t)max(r-F(0),O]
(14)
which is equivalent to the fraction t o f a put option on an asset with time t+1 state 0 value V(0) and
exercise price V. The time t value o f this option will be:
4>=A{(T)max[F-r(0),O]}
(15)
If instead, the same firm is levered, the bondholders and equity holders can separately tax trade their
respective securities. Consider the equityholders. The exercise price of their tax option is S. The time
t+l state 0 value o f the asset on which their tax option is written is the equityholders claim
max{V(0)-[R+D(0)],O}. Hence the tax option o f the shareholders is:
(r)max&-max[F(0) -R ->(0),O],O}
32
(16)
which is equivalent to the fraction r o f a put option on an asset with time t+1 state 0 value
max{V(0)-[R+D(0)],O}- and exercise price S. The time t value o f this option will be:
(t>1=A[(r)maxiS-max[F(0) -R -D(0),O],O}]
/ 1 -j\
In similar fashion, the tax option o f the bondholders at time t will be:
(r)max{) -m in [F (0 )^ +D(0)],O}
(18)
The time t value o f this tax option will be:

=A[(r)max{D-min[F(0)^? +D(9)],0}]
(19)
If instead, the same firm uses additional financial instruments besides debt and equity, the investors
o f different classes o f securities will separately exploit tax advantages. The shareholders' tax option
will be:
(T jm a x L y -m a x tF C e )-^ -!^ )-^ -^ )^ ]^ }
(20)
which is equivalent to the fraction t o f a put option on an. asset with time t+1 state 0 value
max [F(0) -R -D(Q)-Q-F(Q'),0] and exercise price S. The time t tax value o f the shareholders' taxtiming option will thereby be:
(J>s=A[(r)max{-max[P[9 )
_?~^T9),0],0}]
(2 1)
Similarly, the tax option o f the investors o f the other financial claims at time t will be:
(r)max(F-max{O,min(F(0) W )
(22)
33
The time t value o f this tax-timing option will be:

4V=A[(t)max(F-max{O,min{7(0) -(>(0) +),0+F(0)]},O)]
(23)
The tax option of the bondholders at time t will be:

(t)max{> -m in[F(0),F +>(0)],O}
(24)
The time t value of this tax option will be:

<$D-A[(r)max{>-m in[r(0)^ +>(0)],O}]
(25)
Based on the above formulations, we now arrive at the following proposition:

Proposition I: The value o f the tax-timing option on the shares o f a firm using equity and debt is at
least as good as that using equity solely. Furthermore, the use o f additional securities, including
derivative instruments, can raise this tax-timing option value; it can raise this tax-timing option
value strictly i f the tax-trading opportunities fo r the investors in these additional securities are not
perfectly synchronous with those o f common stockholders.
Proof. To simplify the notation, let
Z 5(0)=S-m ax[F(0)-A ->(0)-0-F (0),O ]
(26)
Z F(0) =F-max{O^nin(PX0) -D (0 ) - , 0 +F(0 )]}
(27)
Z D(Q) =D-miii[V(Q)yR +>(0)]
(28)
34
From appendix A, we will have:
5 ( 0
- Z
F ( 0
+ Z
( 0
V- V(Q)
( 2 9 )
By the convexity o f the max{.,.} function, we have:

(v)maxlV-V(Q),0\
=(-c)max{Zs(6) +Z F(Q) +Z D(0),O}
<(t)max(Z S(0),O1 +(x)max(Z F(0) +Z a (0),Ol
<max(Z5(0),O} +(x)max{Z F(0),OJ +(r)maxiZ (0),O}
(30)
The right hand side o f (30) is the sum o f the aggregate firm tax option values at time t+1, when
additional securities besides debt and equity are used. It follows, therefore, from the linearity o f the
state-preference valuation operator that:
(31)
with the inequality holding strictly unless:

F[Z S(0)X) IZ (0)X)] =F[Z Dcey>0 \Z *(0)X)]=1
(32)
F [Z F(0 )X )|Z D(0)X)] ^ Z ^ O J X J I Z ^ O ) * ) ] =1
(33)
F[Z s(d)X) IZ F(0)X)] =F[Z F(d}> 0 1Z 5(0)>O]=1
(34)
and
for all 0, where F(. | .) denotes conditional probability.

Hence, if there are some states o f nature wherein the additional securities or bond prices are
35
not perfectly synchronous with those o f stocks, (30) will be strictly satisfied, and the addition of
bonds and other financial instruments will strictly raise the tax-timing option values. Therefore, the
additional class o f securities will provide tax-trading opportunities for the investors as a whole.
When the prices o f stock, debt, as well as other securities including derivatives, in some states, move
in opposite directions in trading, the investors can exploit tax-timing options by realizing losses
immediately, while deferring gains. The firm's market value will therefore be greater because of
these profitable trading opportunities created. In fact, because debt, equity, and other financial claims
differ in duration, seniority, and claim specificity, and also represent competing claims on a firm,
it is likely that the prices o f these securities might move in opposite directions in trading. Thus, taxtiming option value can be exploited.
3.4 An Illustrative Example.

In this section, we use a simplified example, extended from Lewellen and Mauer (1988), to
illustrate Proposition 1 and argue that the addition o f securities will give rise to a tax-timing option.
To discuss these issues in the simplest possible setting and through closed-form solutions, we make
a number o f assumptions.
We assume that investors are risk neutral and that the interest rate over the interval t, t+l is
zero. These assumptions suggest the investors are end-of-period wealth maximisers, and the end-ofperiod mean values o f the firm's securities prices equal to their beginning-of-period values. From
equation ( 15), the time t values o f the one-period tax-timing option on an unlevered firms equity are:
^ ^ K ^ m ax C F -^ O )]
(35)
36
where V is the firm random time t+ l market value. E(.) is the expected value operator. From (17)
and (19), the corresponding time t values of the one-period tax-timing options on an otherwise
identical levered firm's equity and debt are:
=s ^
d =C^)^[max(5-1Sr,0)] +[max(> -AO)]}
(36)
S and D are the random time t+1 values o f equity and debt when the firm is levered.
Finally, from (21), (23), and (25), the time t values o f the one-period tax-timing option on
a firms equity, debt, and additional financial instruments are:
. -/
,
=(T){[max(iS -S ,0)] +[max(Z> -D ,0)] +E[max(F-F,0)]}
(37>
S \ D ', and F are the random time t+ 1 values o f equity, debt, and additional securities. (Note that S '
and D ' will generally differ from S and D because o f the presence of these additional securities.)
We assume that D and V are normally distributed as:
D~N(D,
o2d),
with D > > aD
V~ N(Vt o2y ), . with
V > > av
The assumptions D > > oD and V > > Qy avoid the possibilities that D and V can be negative.
Since the interest rate is assumed to be zero over the time period t, t+1, there is no default on the
interest payment promised to bondholders at time t+1. For levered firms, we have
37
S = V
(38)
so
S - N(S, 4 )
where 4 1 r + 4
2coviV, D ), and S=V-D . We also assume S > > as to avoid the
possibility that S can be negative.

To simplify the example further, we assume that no payment promised to the additional
security holders, and D - D ' and D=d ' . For the same firms who add other financial instruments
besides debt and equity, we have:
(39)
s' + F = S
Since they swap equity for these other instruments.

Rearranging:
(4)
S' = S - F
Assume F are normally distributed as F~N(F,a%), with F > > op .

so
where a*, =
g -N (S ', a] ,)
+ azF - 2cov(S, F) and S '= S -F
Under the normality assumptions (see appendix B),
<&s = [max<S-S,0}] =
(41)
Similarly,
38
and
= d / '/2 k
(42)
(43)
(44^
ov/\J2 tz
Therefore, to be consistent with the results obtained by Lewellen and Mauer(1988), we have
* u L < * y jr m
< W (0 )]
= (t){ [o ^ o l - i c o v i v M ^ ^ o ^ c rc o )]
(46)
$ =(r )[o1y '+oo '+af]l/*(0)]

= (0 {[ s -2cov{StF )\i a ôD,+a5)(/"(0)]
('47'>
where f'(0 )= l/y fliz, is the standard normal density function evaluated at zero.
The tax-timing option valuation gains from leverage are:
GCZ)<6 - <J>M:K x)([ o ^ O d - 2 cov( ^ ) ] w * od - o 1J (/-(0 )]
=(r)([To - 2 p ( ^ j 5 ) < j ^ j
+oD - o j i r m
where G(L) is the tax-timing option gains from leverage, p( V, D ) is the coefficient o f correlation
between V and D . From Proposition 1, we know G(L) is no less than zero. It is also evident that
G(L) is decreasing in p( V, D ). That is, the more correlated are changes in the total market value at
time t+l and the market value o f debt, the smaller the tax-timing option gains from leverage.
Extremely, if p( Vt D ) =1 and ov a oD, G(L) is equal to zero and leverage does not enhance taxtiming option values. On the other hand, the less correlated are the changes in the total market value
39
at time t+1 and the market value o f debt, the larger are the tax-timing option gains from leverage,
which is maximized when p(V, D) is equal to minus one.
Furthermore, the addition of other financial instruments raises the tax-timing option
valuation, since
=(t){[o l+ o l-2 c o ^ J r )]l/2+oD+o^\f'(p)]

-O O C ^ zJIT C O )]
(4 9 )
= (r){[oâJ-2p(S r/ ) o so/r]ly2+oF- a5}l/'( 0)]
When the firm adds other financial instruments, the potential tax-timing option gains G(F) also
decreases in p(S, F). The more the changes in the prices o f other financial instruments are linked
with those o f the equity values o f leveraged firms, the fewer tax-timing option gains are obtained
by adding other securities besides debt and equity. If p(S, F )= l and as ^ a F, G(F) is equal to zero
and no tax-timing option gains are obtained. On the other hand, as the degree o f correlation between
changes in the prices o f other financial instruments and those o f the equity values o f leveraged firms
decreases, the associated tax-timing option gain increases and is maximized when p(S, F) is equal
to minus one. Thus, firms can maximize the value o f tax timing options for their investors by
issuing financial instruments whose price changes are minimally correlated with those o f other
securities in its capital structure.
3.5 Security Holder Tax-character Option

One o f the general tax issues raised by derivatives is whether gains or losses from a
derivative transaction are capital or ordinary. Taxpayers generally prefer ordinary expense to capital
40
loss and capital gain to ordinary income. Derivatives have the capacity to create risk characteristic
ranging from the low-risk investment end o f the spectrum (characteristic o f noncontingent debt),
thereby creating the ordinary income or expense, to the no-investment, high risk end of the spectrum
(characteristic o f forward contracts), thereby creating the capital gains or losses. Therefore, the
taxpayers can generate inconsistencies by claiming that a loss position was an ordinary one, while
claiming that a gain position was speculative and therefore capital. The effective tax rates o f capital
and ordinary gains and losses are different. For example, in Canada, only 3/4 of capital gains are
taxed and similarly only 3/4 o f capital losses are deductible from taxable capital gains. Therefore,
we further revise assumption (3) by denoting that the effective tax rate of capital gain (tcc) is lower
than that of ordinary income (toi ), and the effective tax rate o f capital loss ( to .) is lower than that
o f ordinary expense
( toe
). With this revised assumption, we arrive at the second proposition.
Proposition 2: Assume the tax rate on capital gains is not higher than the tax rate on ordinary
income and the tax rate applicable to capital losses is not higher than the tax rate that applies to
ordinary expenses. When taxpayers realize losses immediately, they claim these losses as ordinary.
Proof. Assume a proportion o f a o f the loss from other securities is truly ordinary expense and a
proportion of 1-a o f the loss from other securities is truly capital loss. Then the tax option value is:
(r)max(Z 5(0),O} +(t)max{Z i>(0),Ol+
a (r 0)max(Z F(0),Ol +(1 -a X f^ m a x lZ F(0),Ol
<(T)max{Z'y(0),Ol+(T)max{Zo(0),O}+
a ( r 0)max(Z F(0),O} +(1 -aX *0s)maxiZ F(0),Ol
=(t)max(Z *(0),O} >(r)max{Z (0),O> +(r0)max\Z F(0),O}
(50)
The inequality is obtained because Tclstoe.

The proposition is an optimal tax trading policy for the taxpayers to use the tax-character
41
option, which will mobilize the taxpayers to switch capital loss into ordinary expense, and thereby
avoid the tax disadvantages related to capital loss.
Consider the example in the last section. Assume a proportion a o f the losses from additional
financial securities is truly ordinary expense and a proportion 1-a o f the losses from additional
financial securities is truly capital loss.
This tax-character option is valuable since
'WOftrwi -axtÔftrco)]
<(T)[oôJ-2p(4F)osof.],/J[r(0)]-Wost/~()]
<W W W ]
The inequality is due to *Cl* zoe-
3.6 Minimizing Corporate Income Taxes Using Derivatives

In sections 3.3 and 3.5, w e analyse personal tax situations and indicate that adding other
financial instruments can enhance a firms market value. Other financial instruments confer on the
investors tax-timing options and tax-character options. In this section, we assume that corporate tax
exists. We will provide a similar analysis, and show that firms can realize losses immediately and
delay gains using derivatives and thus increase their market value.
A derivative security is a financial contract written on the price o f an underlying asset
(Jarrow and Turnbull 1995). Its value is based on or derived from the value o f something else, such
as an index or another financial instrument (Baer 1994). Futures, forward, swaps and options are all
examples of derivatives. Even though we do not analyse all kinds o f derivatives here, nor provide
a general theory o f minimizing taxation using derivatives, we do offer a theoretical analysis of the
42
tax-timing option value, similar to the framework given in former sections. In this section, we
describe the analytical framework first, and then review three examples.
3.6.1 Analytical Fram ew ork

To begin with, there are six assumptions:
1. It is a multi-period model o f firm asset value.
2. Capital market is perfect with zero transaction costs
3.
is the uniform corporate income tax rate, where 0< t<1.
4. Firms are risk neutral and market value maximisers.

5. Random end-of-period firm asset values are normally distributed. Risk free interest rate is zero.
6. Mean firm (security) end-of-period values are sufficiently large relative to their variances, and
thus ignore the negative outcome.
Assumptions (5) and (6) are for analytical tractability.
Similar to the argument in section 3.2, we argue that the recognition o f only one tax-trading
strategy at t+ l suffices to establish the conclusion. Hence, we take the market value o f the firms
security at t+ l as exogenously given and not dependent on future tax-trading benefits. Within this
framework, the market value o f a firms security at time t+l is M, where M-NfMyO2) . The time t
market value o f the security is M . The firm will realize losses immediately, i.e., when M<>M, the
tax-timing option is
; but defer gains, i.e., when M>M, there is no trading, and thus the tax-
timing option value is zero. Accordingly, the total time t market value, which is included the taxtiming option, is:
r=A?+[(T)max(Af-A/,0)]
(52)
43
By the assumption that market value is normally distributed, the firm market value can also
be presented as:
(53)
V = M + (z)\f'm a
w here/(0)=l/(27t)1/2
In the similar fashion, if the firm invests in two securities, security A and security B, with
the time t+l market values normally distributed, i.e., MA~N(MA,oA), Mg-NQdâ^). Its aggregate
market value at time t will be the sum o f the values o f its constituent securities, and (53) can be
rewritten as
VAB = M
+ M
+ ( r ) [ / * (0 )](< rj + <t \ + I p .AB<rAcrB) {-n
(54)
If the firm can separately trade security A and Bwith no concurrent change in the market
value o f either security, the firm can exploit the tax-timing option value separately. With the separate
trading available, thus the values o f these securities to the firm, at time t, will be
VA = M
+ ( r ) [ / * (0 )]< rA
(55)
VB = M
+ ( r ) [ / * (0 )](Tb
(56)
Therefore, with separate trading available, the tax-timing option value gain is:
vS vi ~ ( x i =(T)l/"(0)][o,
- ( o / t o , 2 *2p,u a/(a J)1Q]
(57)
This tax-timing option value gain is no less than zero. As p AB, the coefficient o f correlation
o f A and B decreases, the tax-timing option value increases. Extremely, when p AB - - 1 , the prices
44
o f securities A and B move in opposite directions, the tax-timing option value is maximized. ft
suggests that firms should optimally invest in two securities, with the market value changes in one
security is least like the changes in the other.
Derivatives, by their nature, are generally used to hedge the price risk of underlying subjects
(real or notional asset, reference rate, index, or other subject matter). The changes in their values are
generally opposed to those o f underlying subjects. If the firm invests in an underlying subject and
a derivative security that hedges the price risk o f this underlying subject, then the coefficient of the
value o f derivative and the underlying subject will be negative, tax-timing option value is thus
obtained. Hence, we arrive at the following conclusion.
Conclusion: Firms prefer to use derivatives to exploit tax-timing option value, when the
coefficient o f correlation o f changes in the values fo r the underlying subject and the derivatives,
which hedge the price risk o f the underlying subject, is minus one, and thus maximize the tax-timing
option value.
Now we relax assumption 3 and assume that the tax rate for ordinary expenses x0E is larger
than the tax rate for capital losses t ^ . From the tax-timing option equation, we know that
(.ôd> \f'm \9 A* o ,< a A2 *a,2 - 2 pAtaAaa)'J2p( t CI) [ r ( 0 ) ] [ a ,
*V
_2p ^ saCIs ) l/3]
Hence the firm will realize losses ordinary rather than capital. The tax-character option value is:
KW -(tCI)][r
^ -(o ,2*V
(59)
45
3.6.2 Three Examples

The first example is explained by Mcdonald (1986). A firm makes a forward commitment
to purchase a loan, and sells futures contract to hedge the interest risk. If the interest rate rises, the
loan shows a loss. The firm will sell the loan and realize the loss. On the other hand, if interest rate
falls, the loan shows a gain. The firm will not sell the loan and defer the gain. This hedge is
obviously for the tax benefit, and would be disallowed by tax rules (IRC Sec. 1221, GAAR
ITASec.245). However, if the hedge could be disguised, the hedging tax rules would be ineffective.
The second example is described by Constantinides and Scholes (1980). They argue that,
using two call options on stocks (writing a call and buying a call), losses on one options can be
realized but gains on another option can be deferred. The hedge can be manipulated and thus the
hedging tax rules and the wash sale rules do not apply.
The last example is described by Thornton (1998), and Macnaughton and Thornton (2000).
Canadian Pacific Limited issued New Zealand bonds in 1987 and Australian Bonds in 1989. At the
time the bonds were issued, the inflation rates in New Zealand and Australia exceeded the Canadian
inflation rate, and investors expected NZ$ and AS would depreciate relative to CS. To attract
investors, the interest rates on the bonds, which were denominated in NZ$ and AS had to be higher
than that on similar bonds, denominated in C$.
The interest rate is only one consideration. Another consideration is the principal value to
be paid. Countries with higher inflation rates than Canada, e.g., New Zealand and Australia, expect
to see their currencies devalued in the future against the Canadian dollar. Hence Canadian Pacific
Limited would expect to repay less than it borrowed in terms o f Canadian dollar. If capital markets
were frictionless and there were no taxes, the company would be indifferent between borrowing in
Canada and borrowing in New Zealand or Australia, since it would expect depreciation in foreign
46
currency values to compensate for higher foreign interest rates - covered interest parity.
The amount of depreciation on foreign currency is uncertain. If the depreciation on NZS or
AS is less than expected, the future cost o f repaying the loans in Canadian dollar would be higher
than expected. Thus borrowing abroad without taking any steps to offset the foreign exchange risk
is like speculating in foreign currency market. To eliminate this risk, Canadian Pacific Limited
entered into a number of forward transactions governed by Master Forward Agreements to hedge
the interest and principal payments into Canadian dollar. The agreements specified the exact forward
prices in Canadian dollars, at which the company would buy NZS and AS to pay interest and
principal. Any gains (losses) on the amount o f principal to be paid is then exactly offset by the losses
(gains) on the forward contract. Without tax, such loans are not substantially different from Canadian
loans. However, there is a tax saving opportunity available for the company.
In the forward currency contracts, the forward exchange rates were lower than the spot
exchange rates since the foreign currencies (NZS and AS) are expected to devalue against Canadian
dollar. The spot exchange rate o f New Zealand dollar to Canadian dollar was 0.8153; the forward
rate o f exchange was 0.6225. The spot exchange rate o f Australian dollar to Canadian dollar was
0.9615; the forward rate o f exchange was 0.4828. The difference between the forward rate and the
spot rate is called a discount. By making such forward commitments, the company locked in a gain
equal to the discount on the forward contract times the face value amount o f the loan. Hence the
interest rates on the bonds were more than those if domestic bonds were issued, while the principal
payments were less than those if domestic bonds were issued.
In each year, the company took the interest deductions, which exceeded those that were
available on Canadian bonds.
Regarding the time when the company should recognize in income the benefit o f the
47
discounts on the forward currency contracts for accounting purposes, ways were debated: (1) later,
when the contracts mature; or (2) earlier, gradually over the life of the bond issues.
Given the optimal tax-timing and tax-character strategy, it is not surprising if the company
used the first method to compute its taxable income. That is, recognized the discounts when the
contract matured, and recognized the discounts as capital gains, only taxed at 3/4 o f the tax rate
for the ordinary income. Actually, to calculate income for tax purposes, the company did not
recognize any o f the discounts in any years before the bonds matured. When the debts matured,
the company recognized the forward discounts as capital gains, which were subject to 3/4 of the
tax rate o f the ordinary income. Therefore, for tax purposes, by using the synthetic loans, the
company recognized the higher interest expense deductions, without recognizing any gains from the
forward contracts, each year before the loans matured.
Empirically, we may test whether firms use of derivatives can be partially explained by tax
reasons, and test the relation between firms use o f derivatives and their unrealized or realized
gains/losses. If firms use derivatives to exploit tax-timing value, we expect that the use o f derivatives
is positively related to unrealized gains and realized losses. In the next section, we specify these tests
in detail.
3.7 Empirical Evidence on Corporate Use of Derivatives to Manage Taxes

In the previous sections, we provided an analytical framework to show that firms can use
derivatives to exploit tax-timing option value, i.e., realizing losses immediately but deferring gains
indefinitely, and tax-character option value, i.e., realizing gains as capital gains but realizing losses
as ordinary losses, thus increasing their market value. We examined three examples and showed that
48
taxpayers co uld use forwards, futures, options, swaps, etc. to exploit tax-timing option value and taxcharacter option value.
In this section, we will provide empirical evidence on the extent to which firms use
derivatives to minimize taxes. We will utilize a cross-sectional 1997 corporate data listed on the
EDGAR database to examine the extent to which firms use o f derivatives can be explained by
incentives such as realizing losses immediately and deferring gains, i.e., exploiting tax-timing option
value.
3.7.1 Predictions to be Tested

On the one hand, the more the firms use derivatives, the more losses they realize immediately
(i.e. the more the realized losses) that are deductible. On the other hand, the more the firms, use
derivatives, the more taxable gains they defer to the future (i.e., the more the unrealized and untaxed
gains). Hence we will test the relationship between firms use o f derivatives and their unrealized and
untaxed gains, as well as the relationship between firms use o f derivatives and their realized
deductible losses.
We generate the following predictions with respect to firms use o f derivatives to exploit taxtiming option value:firms use o f derivatives is positively (negatively) related to their unrealized and
untaxed gains (losses), and is positively (negatively) related to their realized deductible losses
(gains).
To supplement the test o f the relationship between firms use o f derivatives and managing
taxes, we provide additional evidence on the extent to which firms use derivatives for tax planning
reasons.
Seyhun and Skinner (1994) provide empirical evidence about the tax impact on individual
49
stock market realization. They use a panel o f individual tax-retum data from the Internal Revenue
Service and classify investors into groups to examine whether individual stock market realization
can be explained by motivations such as: realizing losses short term, deferring gains, or multiyear
tax-timing option, i.e., realizing long-term capital gains to reestablish the stocks short-term basis
and thus increase the probability of realizing short-term losses.
Following the method used by Seyhun and Skinner, we classify firms into three groups: those
realizing taxable gains, those realizing deductible losses, and those realizing neither gains nor losses.
We assume those firms realizing deductible losses are trading for tax reasons, i.e., exploiting taxtiming option value, while those realizing taxable gains are trading for other reasons. Comparing
firms using derivatives with those not using derivatives, the classification will reveal whether firms
using derivatives are more likely to exploit tax-timing option value. The prediction to be tested is:
firms using derivatives are more likely to realize deductible losses, and are less likely to realize
taxable gains.
3.7.2 Sample Selection and Variable Measurement

The variables we need to test the above predictions are: the corporate usage of derivatives,
the unrealized and untaxed gains (losses), and the realized deductible losses (gains). To control for
the influence o f firm size, we scaled the above variables by firm market value or book value o f total
assets. We also need to know how many firms use derivatives (forwards, futures, options, swaps,
etc.), how many firms do not use derivatives, as well as how many firms realize deductible losses
and taxable gains.
Following Berkman and Bradbury (1996), we measure firms derivatives usage by the fair
value or the contract (notional) value of derivatives (forwards, futures, swaps, and options), deflated
50
by the market value o f the firms to control the influence o f firm size. The fair value measure is
defined as the market value or loss on all derivatives outstanding at the fiscal year-end. The contract
(notional) value measure is defined as the sum o f the contract (notional) value o f all derivatives
outstanding at the fiscal year-end.
The measurements o f the usage of derivatives, however are not ideal. The fair value is an ex
post estimate o f the net result o f all derivatives used by the firm. It is potentially noisy and may be
negligible. In addition, the fair value, as an independent variable, is part of the dependent variable the unrealized gains/losses. The contract value is not ideal, either. The contract value is the contract
value o f all derivatives outstanding at the fiscal year end. The linear regression model in this section
is to regress realized losses from financial instruments on the use o f derivatives. We expect that the
realized losses should be positively related to the use o f derivatives. However, when the firms realize
losses by disposing o f derivatives, the derivatives outstanding at the fiscal year end will be decreased
due to the disposition. Hence we should use the derivatives outstanding at the beginning o f the fiscal
year as the independent variable. However, the database we use is only, for one year - 1997, and the
contract value o f the derivatives at the beginning o f the 1997 fiscal year is not available for all the
firms. Due to the weakness o f the measurements o f the use o f derivatives, besides the linear
regression test, we separate the firms into the group using derivatives, and the group not using
derivatives, and do a comparison.
From the theoretical framework, we know that when corporate gains are taxed based on the
realization rule, that is, the gains are taxed only when they are realized, firms will try to defer gains.
When corporate losses can be deducted from gains only on realization, firms will realize losses
immediately. Capital gains and losses are generally subject to realization tax rules. However, the
information about firms capital gains and losses subject to taxation are not available. Under GAAP,
51
firms income statements do not distinguish capital gains and losses from ordinary income and
expenses. Therefore, we assume the gains or losses from the disposition o f the firms financial
instruments are subject to realization tax rules. The unrealized gains from the firms outstanding
financial instruments are not taxable. The unrealized losses from the firms outstanding financial
instruments are not tax deductible. The financial instruments used by the firms include short-term
and long-term debt, investment securities (debt and equity investment), derivatives, etc. Scholes,
Wilson, and Wolfson (1990) measure the unrealized gains (losses) o f the marketable investments
securities as the market value less their book value, deflated by book value of total asset to control
firm size. We follow their measurement, and calculate the gains (losses) from financial instruments
as their market value (fair value) less book value (carry value), deflated by the book value o f total
assets.
Many firms adopted SFAS No. 130, reporting comprehensive income, i.e., the unrealized
gains (losses) from available-for-sale marketable securities and the adjustment for foreign translation
should be disclosed in the consolidated statement o f stockholders equity. The requirement is
effective in January, 1998, and many firms disclose this type of information at the fiscal end o f
December, 1997. In addition, from the notes accompanying the financial reports, firms disclose the
fair values o f financial instruments they use under the item o f fair value o f financial instruments. The
fair values o f the financial instruments are generally based on the quoted market prices for the same
or similar issues, or on various methods: external valuation, discounted cash flows, etc. They also
disclose the carrying values o f the financial instruments they use. We measure the unrealized gains
(losses) by fair value less carrying value (book value) o f the outstanding financial instruments. The
realized losses (gains) from the disposition o f the financial instruments can be obtained directly from
financial reports and accompanying notes.
52
We select firms on the EDGAR database with the fiscal year-end o f December, 1997. The
EDGAR database, maintained by SEC, includes U.S. firms files called 10-K reports. The reports
disclose comprehensive information on the U.S. firms, including business and properties,
environmental proceedings, financial'activities, financial reports, and supplementary data,
compensation, security o f ownership, etc. Most importantly, following new guidelines introduced
by SEC in 1997, the reports disclose information about firms use o f derivatives and hedging
activities: what types o f derivatives the firms uses, the year when the firms use derivatives, and the
year o f maturity, the contract (notional) value of derivatives, as well as their fair market value at the
end o f the fiscal year. Therefore, the firms use of derivatives, which is measured by the contract
value or fair value can be obtained from the EDGAR database under the items of market risk
management, hedging activities, derivative financial instruments, etc.
We exclude firms in the financial services sector because their tax m les and derivatives usage
are very different from other firms. We also exclude firms that were merged and reorganized during
1997. Table I provides a summary o f the sample selection criteria. A further requirement for the
firms on the sample is that the market value o f equity o f the firms should be over $2.5 billion, since
the SEC (1997) mandated market risk disclosure rules initially applied to those firms.
Among the final observations o f 209 firms, 32 firms do not use derivatives in 1997 and
before; 177 firms use derivatives. Among the 177 firms that use derivatives, 155 firms have
outstanding derivatives at the fiscal end o f 1997, and have contract (notional) value or fair value
available in the database; 6 firms have zero outstanding derivatives at the fiscal end of 1997 but used
derivatives in previous years; and 16 firms make limited use o f derivatives, with immaterial amount
and no contract (notional) value or fair value available in the database.
The firms in our sample come from a broad range o f industries: computer and electric
53
service, manufacturing, mining, food industry, wholesale and retail, transportation, etc.
All the 209 firms disclose the contract (notional) value o f the derivatives they used at the
fiscal end o f 1997. However, only 167 firms provided the fair value o f the derivatives, or said that
the fair value was immaterial. The other 42 firms did not give the fair value o f the derivatives they
used. Therefore, we use contract value o f derivatives to conduct the following empirical tests.
Table 2 provides descriptive statistics o f the level o f derivatives held by the firm s at the 1997
fiscal year-end, obtained from the E D G A R database. The contract values range from zero to 1.2031
o f the market value o f the firm. The mean is 0.1092, and the median is 0.0546 for the whole sample.
For those firms using derivatives, the contract values range from 0.0007 to 1.2031 o f the market
value o f the firm. The mean is 0.1473, and the median is 0.0907.
Table 3 reports the characteristics o f the derivatives for the firms with derivatives outstanding
at the fiscal year end o f 1997 (155 firms). The derivatives the firms use include swaps, forwards,
futures, and options related to interest rate, foreign currency, commodity, and equity. Interest swaps
and foreign currency forwards are the most common derivatives used by the firms.
Tab le 4 reports descriptive statistics o f the independent variab les and other relevant variab les
that we use in the empirical test: firm market value, unrealized gains, realized losses, both scaled by
the book value o f total assets. For each o f these variables, table 4 reports the means, standard
deviation, medians, m inim um value, and maximum value for all the firms.
Table 4 shows that the mean o f unrealized gains is negative, i.e., the firms had unrealized
losses on average. The mean o f realized losses is positive, i.e., the firms had realized losses on
average. The bias towards losses (either realized or unrealized) may reflect the fact that derivatives
are costly to use. It may also imply that the measurement o f the losses or gains is not precise. The
losses and gains are measured only for financial instruments, and thus ignore many other underlying
54
transactions. For example, a firm uses a futures (long position) to hedge the price of the raw
materials. When the price o f the raw materials falls, the futures shows a loss, while the firm can buy
the raw materials at a lower price. Our measurement o f gains and losses, which is limited to the gains
and losses from the financial instruments,'shows a loss.
The bias towards losses may also be due to the fact that there is only one-year data used in
the test. In this empirical work, we use firms 1997 data. Many companies may have similar
exposures that have been hedged, resulting in many companies having derivatives that present the
same type of exposure, e.g., most companies are long a foreign currency due to foreign purchases
(foreign purchases o f inventories, fixed assets, and so on), and have taken offsetting short position
in the foreign exchange derivatives m arket Hence a strong US dollar in 1997 may result in
unrealized losses on foreign exchange derivatives across firms.
Table 5 reports means and medians o f independent variables for firms with derivatives (177
firms) and without derivatives (32 firms) separately. A z-test, based on the Scheffe test, is
undertaken to test the difference in the means o f the market value, the realized losses, and the
unrealized gains, between firms using derivatives and firms without derivatives.
Table 5 shows that the average market value for firms without derivatives is lower than that
o f firms using derivatives. It may reflect the economies o f scale o f using derivatives. It also shows
that firms using derivatives realize, on average, significantly more losses than firms without
derivatives. It supports the prediction that firms use derivatives to realize losses. Furthermore, table
5 shows that firms with derivatives have, on average, significantly more unrealized gains (i.e., less
unrealized losses) than firms without derivatives, which supports the prediction that firms use
derivatives to defer gains. In the next section, we use a linear regression model to test whether firms
use derivatives to manage taxation. The linear regression model tests the relationship between firms
55
use o f derivatives and unrealized gains (losses), as well as the relationship between firms use of
derivatives and realized losses (gains).
3.8.3 Model and Results

We use the following linear regression model and define the dependent variable as:
(60)
y (=a+Pr,+e,
In the regression, the dependent variable y t represents the vector o f firms unrealized gains (losses),
and realized losses (gains) o f financial instruments. The independent variable xt represents the firms
use o f derivatives (contract value), a is the intercept. (3 is the coefficient, measuring the relationship
between firms use o f derivatives and their unrealized losses (gains), as well as their realised losses
(gains). e{ are residuals, which are independently and identically normally distributed, with mean
zero and variances o2.
Table 6 reports the result o f the relationship between the contract value o f derivatives and
unrealized gains. Table 7 reports the result o f the relationship between the contract value of
derivatives and realized losses.
The coefficients show the predicted signs for all the regressions. Regression results from table
6 show that firms unrealized gains from financial instruments are positively related to their use o f
derivatives, after controlling the influence of firm size. It supports the prediction that the more the
firms use derivatives, the greater the unrealized gains from financial instruments.
The regression result from table 7 shows that firms realized losses from financial instruments
are positively related to their use of derivatives. That is, the more the firms use derivatives, the greater
the losses they realize.
56
However, the results on table 6 and 7 are not significant, which casts doubt on our
conclusions. It may be due to the fact that the measurement of the variables are not precise: the
measurement of the derivative usage, and the realized/unrealized losses/gains are not precise. ft may
also be due to lack o f materiality. In addition, the regression test is quite simplified to the extent that
there is only one explanatory variable. Hence it ignores other factors that may affect firms realized
losses or unrealized gains, e.g., firms marginal tax rates, hedging costs, and so on.
To supplement the evidence about whether firms use derivatives for tax purposes, table 8
describes whether firms using derivatives are more likely to exploit tax-timing option value (realizing
losses but deferring gains). Table 8 shows, among the firms using derivatives, how many firms realize
losses, and how many firms realize gains. Among the firms not using derivatives, the table shows
how many firms realize losses and how many firms realize gains.
Table 8 provides the proportion o f firms in each o f the three groups at the fiscal year-end of
1997. The results show that firms using derivatives are more than twice as likely to have realized
losses as firms not using derivatives. Among firms that use derivatives, more firms realize losses than
realize gains. Among firms not using derivatives, however, more firms realize gains than realize
losses. The result suggests that firms using derivatives are more likely to realize losses to exploit taxtiming option value than firms not using derivatives.
3.8.4 Summary and limitation

We provide empirical test on the relationship between firms use o f derivatives and their tax
strategies, i.e., realizing losses and deferring gains. The results are generally consistent with the
hypothesis that firms use derivatives to exploit tax-timing option value. However, the linear
regression test provides a very preliminary evidence with a relationship between tax-timing option
57
value and the use o f derivatives. We do not control for other factors, e.g., firms marginal tax rates
and hedging costs, for the tests, even though we control the effect o f firm size. Additionally, the
realized and unrealized gains/losses we calculate are the gains/losses o f financial instruments,
including only the short term and long term debt, investment securities (debt and equity investment),
and derivatives (futures, options, swaps, forwards, etc), thus ignoring the gains/losses of many
underlying transactions (e.g., foreign sales, inventory purchases or sales, and so on), which are not
explicitly highlighted in the financial statements. Ideally, the empirical work should examine the
unrealized gains and realized losses simultaneously. However, due to the problems mentioned above,
the approach in the paper is looking at the unrealized gains and realized losses in isolation.
We do not test whether firms use derivatives to exploit tax-character option value, i.e.,
whether they use derivatives to realize losses as ordinary but realize gains as capital, given that the
tax rate for capital gains is lower than ordinary income. Since in the U.S., the tax rate for capital gains
and ordinary income is the same, it is more difficult to test the tax-character issue. It may be feasible
to collect data for Canadian firms and do the test, given the tax rate for capital gains being 3/4 o f the
tax rate for ordinary income. However, we did present anecdotal evidence (the case o f Canadian
Pacific Limited) that was consistent with this conjecture.
The firms we examine do not encompass the financial service sectors. There are some existing
studies that focus on banks tax planning and their financial decisions (Froot and Stein 1998, Beatty
et al. 1995, Collin et al. 1995, Warfield and Linsmeier 1992, Scholes et al. 1990).
We do not include the incentive stock options when we examine the firms use o f derivatives.
Some existing papers study this special topic (Matsunaga 1995, Huddart 1994, Matsunaga et al.
1992).
58
3.8 Conclusions and Limitations

[n this section, we establish a framework to show that using financial instruments including
derivatives can exploit the tax-timing and tax-character option values. Two propositions are presented
and proved. Proposition one argues that the value o f the tax-timing option on the shares of a levered
firm is at least as good as that when unlevered, and derivatives can further raise this tax-timing option
value. Proposition two argues that taxpayers will realize losses as ordinary rather than capital. An
example shows that the tax-timing option value using other financial instruments besides debt and
stock is negatively related to the relationship between the changes in the prices o f other financial
instruments with the changes in the firm equity values. The more closely linked are the changes in
the prices o f other financial instruments with those o f the equity values, the fewer the tax-timing
option gains are obtained by adding these financial instruments. The result o f empirical test are
generally consistent with the hypothesis that firms use derivatives to. exploit tax-timing option value.
We simplify the model of tax-timing option permitting investors only a single tax-trading
opportunity, at time t+ l. This was done to allow the time t+l total value o f the firm to be treated as
exogenously determined and independent o f subsequent tax trading influences. We also separate the
intrinsic value o f the firms securities, as claimed on the cash flows from its operating assets, from
the identified value o f the tax-timing options on those securities. This is a partial equilibrium
framework. In a more general framework, the tax option values would be subsumed in the security
prices at time t, and those values also reflect multiple future trading opportunities.
We examine separately the tax-timing and tax-character option under personal tax and
corporate tax situation. A more general framework would analyse the situation with both personal tax
and corporate tax simultaneously.
59
Chapter Four:
Effect of Taxes on Firm Valuation under Clean
Surplus Accounting
4.1 Introduction
Chapter three argues that using derivatives to exploit tax-timing option and tax-character
option value generates economic benefits to the firms. In this chapter, we examine tax effects and
firms tax-saving strategies under accounting systems - clean surplus accounting relation.
Feltham and Ohlson (1995) examine the relationship between firm market value and
accounting data such as book value, earnings and dividends in a neoclassical setting under clean
surplus relation. We extend the Feltham-Ohlson model and set up a theoretical framework by adding
corporate taxation - the tax based market valuation model. The framework shows, with corporate
60
taxation, firm market value is expressed as a function o f the bottom line accounting data: the book
value and the abnormal earnings, as well as the corporate tax. Corporate taxation is one o f many
factors that affect firm market value. The framework provides a theoretical base for tax planning to
play a role in enhancing firm market value, and thus to explain why firms exploit tax-saving strategies
and pursue minimized tax payments. Under this framework, we analyse certain issues: tax deductible
accruals, financial and operating activities, dynamic linear information model, tax-timing option, taxcharacter option, agency costs such as financial reporting costs.
4.2 Relevant Accounting under Feltham-Ohlson Model

This chapter examines how corporate tax affects firm market valuation under clean surplus
accounting based on the Feltham-Ohlson (1995) model (F-O model). The F -0 model is a multi-period
model in a neoclassical setting ignoring income taxes. It incorporates three concepts that impose
structure on accounting.
First, the model uses the clean surplus relation (the all-inclusive concept of income): the
income statement contains all changes in owners' equity other than dividends (net of capital
contributions). Dividends reduce book value but do not affect current earnings.
Second, the Modigliani and Miller (M-M) theorem regarding dividends is satisfied. Dividends
displace market value on a dollar-for-dollar basis, so dividend policy is irrelevant to share value.
Third, financial activities are separate from operating activities in the F-O model. Financial
activities involve assets and liabilities for which there are perfect markets. Therefore the value o f the
firms financial assets simply equals their book value. Cash accounting and accrual accounting
coincide for these assets and liabilities, i.e., accounting is perfect in the sense that book value is
61
equal to market value. In contrast, operating assets are typically not individually traded in perfect
markets. Measurements o f operating accounting earnings focus on cash flow adjusted for accruals,
and the use of accounting conventions for accruals and realization o f income generally leads to
significant differences between market and book values o f operating assets and liabilities.
The F-O model also uses a security valuation formula which is standard in neo-classical
models. That is, the present value o f expected dividends determines the firm's market value. In
addition, risk neutrality o f investors applies so that the discount factor equals the risk-free rate.
To study the effects o f income tax on the firm's market value, we will go beyond the neo
classical setting and extend the F-O model by relaxing the assumption o f no taxation. In the next
sections, we will set up a theoretical framework relating firm market value to accounting data
including tax data. Under the framework, we show that future tax payment play a role in determining
firm market value. Firms have motives to exploit tax-saving strategies. We also show how firms can
use accounting principles to exploit tax-timing option value and tax-character option value to enhance
their market value. Empirical implications are also described.
4.3 Tax-based Market Valuation Framework

4.3.1 Accounting Relations
Consistent with the terminology of the F-O model (1995, 1996), we let:
b v t : firm book value, date t
x t : earnings (before tax) for period (t-l,t)
d , : dividends (and share repurchases), net o f capital contributions, date t
62
f a t : financial assets, net o f liabilities, date t (negative for a levered firm)

i, : interest revenues, net o f interest expenses, (before tax) for period (t-l,t) (negative for a
levered firm)
o a t : operating assets (such as plant), net of operating liabilities (such as warranties), date t
o x t : operating earnings (before tax) for period (t-i,t)
crt : cash received from operation at date t
c it : cash invested, at date t
c t : cash flow realized from operating activities (before tax), net o f investments in those
activities, date t
Hence by definition, we have c t = crt - c it
d e p t : accruals from operation for period (t-l, t), e.g., depreciation expense.
Measurement o f operating earnings (before tax) focuses on cash flow adjusted for accruals. Hence
we have x t = crt d e p t 1
Pt : firm market value, date t.
R f : one plus the risk-free interest rate ry .
In addition, we define the following variables:
1 Accruals can be added to or subtracted from cash received in order to calculate operating earnings. For
example, depreciation accruals are subtracted from cash received; cash receivable accruals are added to cash received.
63
Tt : tax deductible accruals, hencexf- r f= taxable income (note Tt can be positive ornegative).
The examples o f Tt are: the depreciation for tax purpose in excess of accounting deprecation; certain
other accruals that differ in the tax and accounting system: e.g., warranty costs are accrued for
accounting purpose but computed on a cash basis for tax purpose; realization o f gains and losses on
derivatives recognized for tax purpose in periods different from financial reporting: e.g., certain
derivatives are marked to market for financial reporting but reported on a realization basis for tax.
t: corporate tax rate.
Corresponding to the accounting in the F-O model, we separate the firm's activities into
financial activities and operating activities. The firm's date t book value is;
(61)
b v= fa + o a t
Operating assets o a t consist o f all asset (liability) accounts that do not generate interestrelated earnings (expenses). Financial assets f a t consist o f all asset accounts that produce interest
related earnings (expenses).
The firms period (t-l,t) earnings (before tax) come from financial and operating activities:
(62)
xt=it+oxt
Operating earning s o x t consist o f all non-interest earnings, financial earnings i t are the
interest earnings.
Structure one accrual, i.e., the depreciation policy to satisfy the clean surplus relation: the
investment, net o f operating accruals, increases operating asset value.
64
(63)
oa= oat^ c i t -dept
The net interest relation (NIR) is:

(64)
' r & p - ty a t - i
The ending stock o f financial assets fa< is expressed as the financial asset relation (FAR):
fa t =/at. i +it -T(xt -Tt) ~(dr ct)
(65)
The firms financial asset value at date t, is the financial asset value at date t-1, plus the
inflows, i.e., the net cash flow from operation and interest earnings from the financial activities,
minus the outflows, i.e., the dividend payoff and the tax payment
From (63), and o x t = crt - d e p t , the ending stock of operating assets oat is expressed as
the operating asset relation (OAR):
(66)
oa= oat_l +oxt-c t
(65) and (66) give another expression o f the clean surplus relation2:
bvt = bvt_x + xt - r(x, - T t ) - d ,
(67)
The firms income (after tax payment but before deferred income tax) net o f dividend payoff
2 The relation uses a taxes paid basis for computing income tax expenses. In this relation, any difference
between tax expense and tax payable is called deferred taxes or future tax asset/liability, and are included in b v t .
65
will be added to its book value3. The relation implies that deferred income tax is incorporated into the
firms book value.
4.3.2 Firm's Market Value and Its Relation with Clean Surplus Accounting Data
The firm's market value, Pt, is assumed to equal the present value o f the expected dividends
discounted at the riskless interest rate R f( the present value relation PVR) (we ignore personal tax):
so
(68)
P .- E R /W - th
/=
From the financial asset system, define the after-tax cash flow as
a tc f t = Ft = c t - r ( x f - Tt ) , then from (64) and (65),
(69)
d r R / a t_x-fat+Ft
As a result, we have one expression o f the tax-based market valuation model:
3The case
Xt
Tt
-< 0 , and thereby r ( x f 7^ ) >- 0 warrants discussion. This does not mean that
the government subsidizes the firm. B y Canadian tax rules, ordinary losses can be earned back to three prior years, to
the extent that there was taxable income in those years. If all losses can not be earned back to prior years, the remainder
can be carried forward for seven years. Capital losses can be carried backward for three years and forward indefinitely.
Therefore, the relation is a simplifying assumption that the current losses can be absorbed by the taxable income in other
years, and the firm can get a refund up to r ( x , Tt )
66
) - 1
=E RFEtlR/ at-l-j-fat-S Ft J
/=1
(70)
30
E V W .,1
/-I
provided R Ê ^f^-] - 0, as j - .
The market valuation function shows that the expected future cash flow net o f tax payment
will determine the firms market value. There is a role for tax-planning strategies to play to the extent
that they reduce the firms present value o f the expected future tax liability.
We can also obtain the relationship between firms market value and its book value, as well
as its abnormal earnings, similar to that given by F-O model. Similarly, we define after tax abnormal
earnings as the firms net income (after tax payment and deferred tax) minus the estimate of normal
income, which is measured as the firms book value in preceding year multiplied by the capital cost
R f -
1. That is xta*{xt-TQcr T )-T :T y iR F-l)b v t_l *.

From (67), and the definition for the abnormal earnings, we have another expression for the
tax-based market valuation model:
4The definition is not the only way to define abnormal earnings. However, by defining abnormal earnings in
this way, we could isolate tax term from other accounting figures in the tax-based market valuation model, and we can
investigate the tax effects on firm market value.
67
/ = 1
/=l
- *
vr-/ +X/ V 'rt^
( 7 1 )
provided RF'JEt[bvt^] - 0, as j -* oo.

The expression shows firm market value is a function of the bottom line accounting data, i.e.,
the book value and the abnormal earnings, as well as the tax data, i.e., the deferred tax - the tax
deductible accruals, multiplied by the corporate tax rate. The tax deductible accruals enhance firm
value to the extent that they defer the firms tax payment to the future without paying interests on the
deferral.
Observations deserve noticing when we study the operating asset system. Similarly, we
defined the abnormal operating earnings as the operating earnings net of tax minus the estimate of
normal operating earnings, i.e., o x at = o x t (1 - r ) - ( R F - 1)o a l_l . We find that, unlike the F-0
model without corporate tax, the information from operating systems is not enough to determine the
firms market value. Besides the abnormal operating earnings, the financial activities contribute to
the firms value through the interest deduction shields, and their effects on the tax deductible accruals.
Since
(72)
From the definition for abnormal operating earnings and (62), the market valuation function (70) is
equal to
68
p t =/, "E RFJEtlct
~Tt -/)]
i -1
=fat H RFJEt\<*t.j-x +oxt~j-at-rzoxt-j ~T0f^-r, v)]

y-l
=/ar+E
- ^ x , v -oafV+r ( - ^ /+ r fv)]
=/ af+E ^ M v - 1
so
t
/=i
y=i
(73)
+ o x j < R f -
l)oafV-i-oa/v]
= 6 v ,* / , [ < , ] +T
/=1
/=1
provided RÊtfoa^] - 0, as j We notice that the interest tax shields - rit+J, determined by the firms financial activities,
enhance the firms market value. Hence the firms capital structure is relevant to its market value. It
is consistent with the argument that debt financing is attractive because the interest payments on the
debt is tax deductible (Chen and Kim 1979, Flath and Knoeber 1980, DeAngelo and Masulis 1980,
Cloyd et ai 1992, and so on).
The tax-based valuation model we have obtained involves in an infinite time period. However,
the interesting issue or the issue useful for empirical work may focus on the limited time period, or
focus on the current time period, i.e.,relate the firms market value to its current accounting
information. Next, we specify a group o f linear dynamic models, and relate the firms market price
to its current accounting data.
69
4.3.3 Dynamic Linear Information Models

The tax-based market valuation model indicates that firm market value is related to the future
abnormal earnings and tax accruals. Hence in this section, we develop a linear dynamic model in
which the current abnormal earnings, tax accruals, book value, and other non-accounting information
provide the basis for predicting the future abnormal earnings and tax accruals.
There are several ways that we could make assumptions about the linear dynamic models.
Before we specify the models, we find that we have to make a dynamic model for the bottom line
accounting data, i.e., the book value and the abnormal earnings, and the tax deductible accruals.
We specify the linear dynamic models as follows5: the abnormal earnings depend on their
preceding years abnormal earnings, the book value, and other information. The tax accruals depend
on their preceding years tax accruals, and other information. The book value depends on its
preceding years book value, and other information. Other information depends on its preceding
years value.
< 1
+ ^ I2^v r + v w +
0 < a>n < 1 , a>l2 > 0
0 < 0)12 -< 1

b v ^ i = &n bV' + v 3, + s 3t+l
1 < a)22 -< R f
v u+t =
Y\
+ *4,+i
V2r+l ~ Y l V2t + ^5r+l
fo llo w in g F -0 (1995), the linear information model seeks to capture three key characteristics o f the dynamics
associated with abnormal earnings, book value, and tax accruals: persistence in abnormal earnings and tax accruals,
growth in book value, and conservative in the accounting for book value.
70
V.v-1 = / j V 3f + e 6e^
I h l h l
Similar to the specifications on the F-O linear information model, ||y h|| < 1, h = l,2,3 ensures
that the random events that influence other information have no long-run effect on future other
information, i.e., E t [vA/+/ ] > O a s y co , h= l, 2,3. The other information is serially correlated
but converges.
The parameter on abnormal earnings COxt represents the persistence in abnormal earnings, and
COl2 represents the nature o f the accounting system: the unbiased accounting (COx2 = 0 ) versus the
conservative accounting (col2 > 0 ). 0 < COn -< 1 restrict the persistence in abnormal earnings. The
lower bound o f COu , i.e., cou > 0 eliminates the oscillating persistence. The upper bound
ry, |
1 permits a positive persistence, but the effect decays over time.

0 < co22 < 1 restricts the persistence in tax deductible accruals. Hence the tax deductible
accruals are going to zero in infinity. It is plausible since the temporary differences between taxable
income and accounting income may disappear in infinity.
1 < co^ -< E f restricts the long-run growth in book value. The lower bound 0 33 > 1 is
necessary and sufficient to rule out E t \ x atJrj ] = E t \b v t+J ] = 0 as j > oo , since we focus on the
going operating concern context. The upper bound *y33 -< R F is necessary for absolute
convergence in the present value calculation.
71
From (71) we have the market valuation relation function (see Appendix C):
d
RFm 12
= iV' +
^11
+J
T +
(74)
where
Rf
(R F -
/?
- <&u)
r^F
[Rf ~
)(R f ~
________________R F _12________________
_ ( R F ~ y z %. r f ~
^ 3 3 )
(74) relates firms share prices to their current bottom line accounting value: book value and
abnormal earnings, as well as the current tax accruals and other information. It is shown that the
parameter on the tax accruals can be zero and thus the tax accruals have no effect on share prices only
when there are no taxes ( r = 0 ) , or the tax accruals are not persistent ( Q)12 = 0 ). Otherwise, the
tax accruals enhance share prices. The higher the tax rate, and the more persistent are the tax accruals,
the more contributions the tax deductible accruals make to the share prices.
We notice that the parameter on book value is positive, and is greater than 1 for conservative
72
accounting systems ( Q)xl > 0 ).

In next section, we discuss some empirical implications on the firms market valuation model
o f equation (74).
4.3.4 Empirical implications

Equation (74) provides the basis for the empirical tests on the relationship between share
prices and the current bottom line accounting data, tax data, and other inform ation. That is, we regress
share prices on current book value, abnormal earnings, and tax accruals or the deferred tax from the
income statement.
Pt = a o +
bvt + a 2x at + a 2Tt + st+l
(75)
There are several existing researches which study the determinants o f share prices or share
returns.
Amir et al (1997) examine the value relevance o f deferred tax components based on F-0
(1995) model. They regress share prices on current abnormal operating earnings, current operating
assets and financial assets, and net deferred taxes. The deferred taxes are measured as the difference
between a book basis and tax basis balance sheet, multiplied by the applicable tax rate (the tax rate
that is expected to apply at the time the asset or liability is expected to be realized). Using the data
from 1992-1994, they find, besides the bottom line accounting data: the abnormal earnings and the
book value, the deferred taxes are value relevant in explaining the cross-sectional variation in share
prices.
Biddle and Lindahl (1982) examine the firms that used LIFO adoption in the mid-1970s. The
firms choice of inventory costing method can result in changes in its cash flows due to the changes
73
o f taxable income. These cash flow effects may affect investor reactions to accounting changes.
Biddle and Lindahl analyse the effect o f the tax saving from LIFO adoption on the firms excess
return. They regress the firms excess return, on abnormal earnings performance, measured by
unexpected earnings, and future tax savings from LIFO adoption.
Biddle and Lindahl (1982) find that the coefficients of both tax saving and abnormal earnings
performance are positive and significant. They conclude that investor reactions to LIFO adoption
depend on the expected present values o f tax-related cash flow savings. After controlling for
abnormal earnings performance, larger LIFO tax savings are found to be associated with larger
cumulative excess returns.
The tax-based market valuation model provides a theoretical framework for the analysis of
the tax effects on firm market value. In next section, we will discuss the tax-saving strategies that can
save tax payment and thus enhance firm market value.
4.4 Accounting Implication of Tax-planning Strategy Exploiting Tax-timing

Option Value
4.4.1 Two-period Case
The tax-based market valuation model (70) can also be expressed as
ao
p, = f a , + I
00
R - / E , [ c , ^ ] - R } JE , [ x , - Tn J ]
/=I
(76)
j=1
am
We argue that the present value o f expected future tax payment
R /E $ e trJ-Tt.j[ reflects
the tax-timing option value depicted by clean-surplus accounting. If the firm realizes the losses in the
74
early periods rather than in the late periods, and defers the gains to the late periods rather than
realizing them in the early periods, the present value o f the tax payment will be lower. Hence the
present value of expected future tax payment reflects the tax-timing option value for the firm.
Assuming the tax rates for capital realizations and ordinary realizations are different, the tax
rate v distinguishing between these two realizations, we argue that the present value o f expected
future tax payment also reflects the tax-character option value for the firm. That is, the firm will
realize the gains at a lower tax rate in order to pay less taxes, but realize the losses at a higher tax rate
to get higher tax deduction.
We analyse a two-period case. The firm chooses accounting methods, i.e., the earnings at each
period,
and x2 , to maximize the present value o f these tax-timing options. That is:
Max -t(Xj -T JR p1-xQ^-T^Rp2
(77)
Assuming the sum o f these two-period gains and losses are fixed respectively, that is,
assuming Gt +G2=G and Ll +Z2=Z under any historic cost accounting system, where G represents
gains and L represents losses. G and L are constant. According to proposition I, the firm will realize
losses immediately and defer gains indefinitely. Now we have the problem o f choosing Gv G2, Lx
and L2 to maximize the tax-timing option values subject to the fixed sum o f gains and losses:
Max -x(xx~Tx)Rf 1-xO ^-T^Rp2
subj ect to
Gj +G2=G
0< G jiG
0 <G2^G
0 <LX<L
75
(78)
0 <LZ<L
We know xx=GX-L t , and x2 =G2 ~L2.
To simplify the model, we assume the tax accruals of each period are fixed, and RF is fixed.
Thus the maximization problem is equal to:
Min (Gj -L x) +(G2 -LJ/Rp.
(7 9 )
(Subject to the former constraints).

Having solved this minimization problem, we get: Gl =0, G2 =G, L x=L and L2 =0. That is, xx=-L
and x2=G. Therefore, under clean surplus accounting, the firm realizes all o f the losses in the first
period while it defers gains until the second period.
Next we will analyse the tax strategies when the firm uses derivative instruments. It is shown
that the firm will still defer the realization o f gains and immediately take losses. Using derivatives
can raise the tax-timing option value and enhance the firms market value.
4.4.2 Tax Strategy Using Derivatives

We classify firm earnings xt into x ^ x , where x " is earnings from derivatives and x / is
firm earnings other than derivatives earnings. Now the clean surplus relation is revised as:
(80)
bvx=bvQ+ x ^ x x" -d x
The last items o f these two equations reflect the tax-timing option values. The firm will
maximize the
tax-timing
option
values, that
is,
the
firm
maximizes the sum of
-z(x ^ -T x) R p - x ^ - T ^ R p 2t -xx^ R p-xxJ'R j,2 (since the tax accruals Txand T2 are assumed fixed
76
in this section, it does not matter whether it appears in the first maximization or the second
maximization). Where xx =Gx - Lx , x " = G " - L " and x2 =G2 ~L2 , x^'=G2 -L2 , we further
assume the sums G '=GX+G2 , G"=G "+G2" and L '=LX+L{ , L "=LX +L2 are fixed. That is, the
total derivatives earnings and other accounting earnings are fixed. The firm will distribute earnings
for each period to maximize the tax-timing option values. The optimal tax strategy for the firm will
be, for a similar reason to the one given in last section, Gx =Gx '=0, and LX=L' , LX'=L"\
G2 =G ' , G2 =G " and L2 =L2 '-Q . The firm defers all gains to the second period but take all losses
in the first period.
Without using derivatives, the firm will defer gains but realize losses. This confers the firm
with a tax-timing option o f Max {-x(xx-T^)RFl -zix2-T^)RF^, 01. By using derivatives, the firm will
manage derivatives earnings xx ,x^' and other earnings*/ , x2 separately. The tax-timing option
ofmanaging other earnings is Max i-x(xx ~TX)RF 1- x(x2/ - TJR^2, 01. The tax-timing option o f using
derivatives is Max {-xxxnRF 1- xx^'Rp2, 0}. It can be shown that, by the convexity o f the max{.,.}
function:
max (-tCxj-T x)R f - x ^ - T J R ^ M
<max. {-xQ c^-TJR p -xQ c^-T ^R Ô }
( 81 )
+ max {-xxxnR pl -xx^'R^fi)
where xx=xx +xx" , x2=x2' -'-x^'.

Therefore, using derivative financial instruments will raise tax-timing option value and
enhance the firms market value.
Empirically, we m ay test whether firms can use derivatives to exploit tax-timing and taxcharacter option value to enhance market value. That is, we may test the relationship between the firm
77
market value and the use o f derivatives that can realize losses and defer gains. However, it is difficult
to isolate the tax-saving purposes from other purposes (e.g., hedging, signalling effects, and so on)
o f the derivatives.
4.4.3 Some Extensions of the Two-period Model

(i) An Analysis o f the Trade off between Tax-timing Option and Financial Reporting Costs
Even though the optimal tax trading strategy realizes losses immediately while deferring gains
indefinitely, we do observe firms realizing gains annually. They even seem to have smooth income
every year (Koch 1981, Bitner and Dolan 1996, Bhat 1996). One reason that prevents firms from
exploiting tax-timing option values is the financial reporting costs, i.e., the costs associated with
reporting lower earnings. Scholes, Wilson and Wolfson (1 9 9 2 ) argue that the firms effective tax
planning cannot be isolated from overall strategic planning, since tax costs and benefits need to be
weighed against nontax costs and benefits. Some researchers argue that management compensation
is linked to both accounting earnings and stock prices through incentive plans (Healy 1985, Ronen
and Aharoni 1989). Since stock prices are related to cash flow distributions expected to be generated
by the firm, corporate-issued reports that change cash flow assessments will affect compensation or
contracts with debt holders. Less accounting earnings may affect management compensation
negatively in a given period. The tax-timing option yielded by the optimal trading strategy may be
offset by accompanying financial reporting costs.
To m a x im iz e compensation, management will "manage" reported accounting earnings.
Management must trade off between the tax-benefits and the accounting reporting costs. On the one
hand, they may wish for the company to appear profitable to facilitate the issuance o f new debt or
equity and enhance internal performance evaluation. On the other hand, they may not wish to appear
78
so profitable when preparing tax returns. However, many transactions and accounting decisions that
result in the reduction o f taxable income also result in the reduction of income reported externally.
Hence while the tax savings that result from reducing taxable income may be attractive, the increased
costs associated with reporting reduced profitability to capital suppliers typically is not. This helps
to explain why so many firms seem to leave significant tax benefits unexploited.
French and Poterba (1991) find that U.S. firms, unlike firms in other countries, often use
different depreciation methods for tax and financial reporting purposes. In fact, 75% of U.S. firms
use accelerated depreciation for tax purposes and straight-line depreciation for financial reporting
purposes. They conclude that U.S. firms pursue the tax benefits o f accelerated depreciation quite
aggressively given that they have lower reporting costs associated with using accelerated depreciation
for tax purposes because they can use straight-line depreciation for reporting purposes and need not
reduce pretax income reported to shareholders.
Furthermore, accounting income and other accounting-based measures are used by providers
o f capital to assess firms debt-repaying and interest or dividend servicing capabilities. Firms that
report low income, for example, will report low interest and dividend coverage ratios, or high
leverage ratios. If such ratios are used explicitly or implicitly in debt or equity contracts, firms that
report lower interest and dividend coverage or higher leverage ratios may experience difficulties in
raising new capital, or incur higher debt charges, or face restrictions on growth opportunities imposed
by current or prospective debt and equity holders. The actual or potential renegotiations o f existing
contracts on terms that are less favourable to the firm constitute a portion o f the firms financial
reporting costs.
To incorporate reporting costs in the tax-timing option model, we suppose part o f management
compensation depends on reported earnings, and financial reporting costs would be negatively
79
proportional to accounting earnings. That is, we assume wt= -Xxt,+vt is the financial reporting costs, A.
is the proportion, which is positive and uniform across the time pexiod ( see graph 1). To simplify the
example, we can also assume that the financial reporting costs only affect the first-period
management compensation. This assumption is plausible if management does not have life-time
employment. The maximization problem is as follows:
The firm chooses Gv G2, Lx, and Z2 to maximize the tax-tim ing option value net o f financial
reporting costs:
Max -x(xx-T x)RF +XJlF
subject to
(82)
G1+G2 =G
Lx
-L
xi ~G\ ~LX
X2 = G 2 ~ L 2
0<Gx<G
OiG2^G
0 <LX<L
0 <L2<L
Ignoring the fixed items RF and T, this maximization problem cam be further simplified as
Max - [ ( t~ W G l ~LX)+xRF (G2-L J]
(83)
(subject to the same constraints).

The maximization solutions are dependent on A., the proportion o f the financial reporting
Costs on accounting eamings (see Appendix D). For example, i f r -k=xRF l , any values are the
80
maximization solutions. If T-X>ri?F' 1, we may get the optimal trading solutions o f realizing losses
immediately while deferring losses. If t-X < tRf ~1, we may defer losses to the second period while
realizing all gains in the first period. The tax-trading strategy does not apply if the financial reporting
costs are large enough ( X>x- tRf ~16) to offset the tax-timing benefits (see graph 2). Therefore, from
this simplified case, we find that management does not always take the optimal tax strategy because
o f the financial reporting costs.
However, the results that the firm either realizes all losses and defers all gains, or realizes all
gains and defers all losses, are quite simplified, since the assumption, financial reporting costs are
negatively proportional the accounting earnings, is quite simplified. For example, when x>0, i.e.,
positive earnings are realized, financial reporting costs will be negative. This is not consistent with
the real world. A more realistic assumption may be to assume the financial reporting costs are a
2
function o f reported earnings: w t - w(;c, )w ith w t > 0 , d w t / ckct < 0 ,an d d w t / dxt
> 0.
For example, assume wt-Xe Xf, where XX). wt is always larger than zero, and is negatively related
to corporate earnings, dw/dxt--X e r*<0 (see graph 3). Solving the maximization problem:
max
-x(xt -T J R p 1-XRFle 11- x Q c ^ -T ^ 2
(84)
subject to:
6 r r R p is the tax savings if one dollar o f income is deferred from period one to period two.
81
C?i+G2 = G
Ly
=^
xl =Gl - Lx
x2=G2 - L2
0<G[ < G
0<G2 < G
0<LX < L
0 <L2 < L
Ignoring the fixed items T and RF, and transferring the maximization problem into the minimization
problem when the negative sign is eliminated, the problem is further simplified as:
min
subject to:
(85)
-L<xx<G
XRF
x, =ln
and -L<x,<G
1
I(* F-1)
'
Assuming RF= 110%, t =50%, we get the function of earnings depending on A,:xx=ln(22A.) (see graph
Then we have the solution (see Appendix E):
4). From graph 4, we find that the earnings of period one can be the value from -L to G, depending
on the value o f X, the financial reporting costs parameter. When financial reporting costs are small
e -L
enough, (0<A.<----- ), the firm will realize all losses immediately and thus exploit the whole tax22
a
timing option value. When the financial reporting costs are large enough (X> ), the firm will
22
realize all gains in the first period to avoid the penalty o f huge financial reporting costs. Within these
two extreme values o f X, the firm can realize any value between -L to G.
When there is a difference between accounting income calculated and taxable income, firms
usually make themselves appear poor to the tax authority to save taxes, but profitable to public
82
investors to avoid financial reporting costs. The last example in 3.6.2 shows that Canadian Pacific
Limited recognized forward premiums gradually every year when it prepared its public income
statement, but deferred the gains until the debt expired in 1994 when it calculated taxable income,
(ii) Tax Accruals for Each Period Are Not Fixed7
In this section, we will relax the requirement that the tax accruals for period one and two
7^ and T2 are fixed. In fact, there are many kinds of depreciation methods. Accounting depreciation
is the proportion of an assets cost which, under GAAP, is allocated to the revenues the asset
generates in each accounting period. Capital cost allowance (CCA) is the
m a x im u m
portion of an
assets cost that taxpayers may deduct each year in calculating their net income or loss from business
or property. The government establishes standard classes, such as buildings, machinery, automobiles,
equipments, and the like. The costs o f the assets belonging to each class are pooled and added
together. The undepreciated balance in the pool is called undepreciated capital cost for the class.
The maximum CCA for the year equals undepreciated capital cost times a prescribed percentage,
specific to the class. These amounts are the maximum management may charge. If earnings are not
large enough to absorb total CCA, it may be a good idea not to charge the maximum CCA for the
year. Hence, unlike accounting depreciation, which is charged every year in the same way, CCA is
taken at the managements discretion (Thornton, 1993).
In this section, we will relax the assumption that tax accruals are fixed beforehand, and
analyse the CCA accrual decision. It is shown that management chooses tax accruals for each period
to maximize firm value.
We note that the summation o f tax accrual, Tx+T2 is zero over the life o f the firm. The
Âctually the tax accruals include all the accruals that differ in the income calculated for accounting reporting
purposes and for tax purposes. Here we only examine one tax accrual - the depreciation expense accrual.
83
management will choose Tt and Ti to maximize firm value. Here, the management will maximize
the tax-timing option value. That is:
b/iax
subject to:
-x(G l -L l -T l)RF - t:(G2~L2~Tj)R f
(86)
Gx+G2-G
Lj
O iG j<G
0 <G2<G
0 <LX<L
0 <L2<L
we assume the tax accruals Tx and T2 are limited to T. That is, | Tx| <T and | T21<T
where t and RF are exogenously determined, and 0<t<1, ^ > 1 . To simplify the problem further, we
assume the gains and losses are not related to CCA, the depreciation for tax purposes. Hence, we are
in a partial equilibrium framework and arrive at a partial equilibrium solution.
Having solved this problem, we get: G Ô , G2=G; Lx=Lt L2=0; and TX=T, T2=-T.
Therefore, firms will take all depreciation in the first period if they are so allowed. The more they
realize the depreciation, the more tax they save.
4 .5 A c c o u n tin g Im p lic a tio n o f T a x -p la n n in g S tr a te g y E x p lo itin g T a x -c h a r a c te r

O p tio n V a lu e
Regarding proposition 2, earnings \ may be both ordinary and capital, xtc and xt , which
are subject to different tax rates. Proposition 2 says the taxpayers prefer capital gains to ordinary
84
income, and ordinary expenses to capital losses. It is simply shown by the two-period model.
P=RF ibvQ-^Gj -L x-bvt -{JoyajGj
- zCL( l -Pi)X J
^ TC G ^
~ccl)Gl
^RF2{bVl +G2 -L2 -bvz - \z Qf HG1
(87)
~a2 ^ 2 ~ZOE$2 ^ 2 ~ZClO ' ^ 2 ^ 2 i + T ^ ,
where a is the proportion o f ordinary income to total gains.

1 - a is thus the proportion o f capital gains to total gains.
P is the proportion of ordinary expenses to total losses.
1 ~P is the proportion o f capital losses to total losses.
xoi is the tax rate o f ordinary income.
xcg
is the tax rate o f capital gains.
xoe
is the tax rate o f ordinary expenses.
x cl
is the tax rate o f capital losses.
Assuming t q/> tcg and ^0E>^CL

If the firm can choose a and P to maximize the market value P , it will let a,=0 and P, =l , (i=l,2).
That is, the firm will realize all gains as capital gains, and realize all losses as ordinary losses, given
the different tax rates. The last example in 3.6.2 shows that Canadian Pacific Limited recognized all
forward premium as capital gains rather than ordinary income.
4 .6 C o n c lu s io n
This chapter analyses the taxation effect on firm valuation under clean surplus relation and
the accounting implications o f the tax-trading strategies o f exploiting tax-timing and tax-character
85
option value. Lt shows that firm market value depends on both the bottom line accounting data, i.e.,
the book value and abnormal earnings, and the tax data, i.e., the tax deductible accruals. This is the
tax-based firm market valuation model. The model provides a theoretical framework for the empirical
analysis o f the effects of corporate taxes on firm market value. Under the model, firms will exploit
tax-timing and tax-character option value to save tax and thus enhance market value. Consistent with
the propositions derived in Chapter 3, the firm will take losses immediately and defer gains; when
taking losses, the firm will realize them as ordinary rather than as capital. However, agency costs such
as financial reporting costs will reduce the tax-timing option value. When firms can choose the tax
accruals for tax purposes, they will accelerate taking tax accruals, and therefore defer taxes.
86
Chapter Five
Conclusion and Summary
While we know that firms generally use derivative financial instruments to manage risk, they
can also use these instruments for tax-planming purposes. Realizing losses immediately but deferring
gains indefinitely (tax-timing option) and realizing losses as ordinary rather than as capital (taxcharacter option) are two tax-trading strategies for firms to
m in im iz e
taxes. Derivatives are flexible
and efficient tools which exploit tax-tim ing and tax-character option value.
The use o f tax-trading strategies m ay affect firm market value. Without corporate taxation,
firm market value is expressed as the bottom line accounting data, i.e., the book value and abnormal
earnings. Tax-planning strategies are irrelevant since there is no role to play for taxation in the market
valuation framework. W ith corporate taxation, we show that firm market value is expressed as the
bottom line accounting data as well as tax d a ta - the deductible tax accruals. It can also be expressed
as the future cash flow net o f tax payment. This tax-based market valuation model provides a
87
theoretical basis for analysis o f the tax effects on firm market value. It is shown that tax-trading
strategies are relevant to the extent that they save tax payment and thus enhance firm market value.
Firm can exploit tax-timing and tax-character option value to save taxes. Agency costs such as
financial reporting costs may decrease, but not eliminate, the gains from tax-timing and tax-character
option. Firms will find an equilibrium between the benefits from tax minimizing strategies and
financial reporting costs. Firms will also take tax deductible accruals to defer tax and thus enhance
its market value.
88
Appendices
Table 1
Sample Selection
Firms listed on the EDGAR database in Dec. 1997
Less: firms in financial services sector*
285
44
Less: firms merged and reorganized
Less: firms with missing data
27
Final number of sample observations
209
* Firms in financial services sector include 21 banks, 18 insurance companies, 3 credit

institutes, I saving institute, and 1 security broker dealer & flotation company.
89
a b l e
Descriptive Statistics of Firms Usage of Derivatives

The table contains descriptive statistics o f the contract (notional) value o f derivatives at fiscal end o f Dec. 1997,
deflated by the market value o f the firm, which is defined as the sum o f the market value o f equity, book value o f debt
and preference capital.
Panel A. All Firms Sample (N=209)
Contract (Notional) Value
Mean
Std.Dev.
Median
Min.
Max.
0.1092
0.1593
0.0546
1.2031
Panel B. Firms Using Derivatives (N=177)
Contract (Notional) Value
Mean
Std.Dev.
Median
Min.
Max.
0.1473
0.1692
0.0907
0.0007
1.2031
90
a b
l e
The table includes 155* firms with positive contract value o f derivatives at the fiscal end o f Dec. 1997.
Swap
Interest rate
Foreign C urrency
Commodity
Equity
Derivatives
Derivatives
Derivatives
Derivatives
Total
97
24
27
153
Forward
79
93
Futures
21
23
Options
49
17
74
Other
23
30
60
Total
131
182
80
10
403
* There are 177 firms using derivatives in the year o f 1997 or in the years before 1997. However, among the 177 firms,
22 firms use derivatives with immaterial amounts and limited outstanding kinds, or they used derivatives in previous
years or during the year o f 1997, but have no derivatives outstanding at the fiscal year end o f 1997. These 22 firms do
not specify what kinds o f derivatives they used in 1997.
91
a b
l e
Descriptive Statistics of Independent V ariables and O ther Relevant Variables

The sample contains 209 firms with fiscal year-end o f Dec., 1997 on the EDGAR database. The unrealized
gains/losses are measured as the market value (fair value) less book value (carrying value) o f the outstanding financial
instruments, including debt, investment securities and derivatives, scaled by book value o f total assets; the market value
o f the firm is defined as the log o f the sum o f the market value o f equity and book value o f both long term and short term
debt, as well as preference capital; realized gains/losses are measured as the realized gains/losses from the disposition
o f the financial instruments, scaled by book value o f total assets.
V ariable
Firm Market Value
Unrealized Gains (Losses)
Realized Losses (Gains)
M ean
10.0619
-0.0049
0.0001
Std.Dev.
M edian
Min.
0.4522
9.9632
9.1746
11.2205
0.0168
-0.0048
-0.0060
0.1133
-0.0457
0.0236
0.0045
92
Max.
a b l e
M eans and M edians of Independent Variables for Firm s with and without Derivatives
The sample contains 209 firms with fiscal end o f Dec. 1997 listed on the EDGAR database. O f these firms, 177
firms use derivatives, and 32 firms do not use derivatives. The firm market value is measured as the log o f the sum o f
the market value o f equity, book value o f debt and preference capital; The unrealized gains/losses are measured as the
market value (fair) value less book value (carrying value) o f the outstanding financial instruments, including debt,
investment securities and derivatives, scaled by book value o f total assets. The realized losses/gains are measured as the
losses/gains from the disposition o f the financial instruments, scaled by book value o f total assets. The Z-statistics in the
exhibit is based on the Scheffe test and tests the difference in the means o f the independent variables between firms with
derivatives and firms without derivatives.
Firms without Derivatives
Firms with Derivatives

*2=177
nv=32
V ariable
M ean
Std.E rr.
M ean
Std.Err.
Firm Market Value
9.8344
Unrealized Gains
Realized Losses
0.2683
10.1031
0.4668
-32.3142
0.001
-0.0059
0.0217
-0.0047
0.0158
-1.9997
0.010
-0.0004
0.0038
0.0002
0.0047
-3.1162
0.005
93
Z-test
P-value
Table 6
Regression Result
The sample contains 209 firms with fiscal year-end o f Dec. 1997 on the EDGAR database. The dependent
variable - unrealized gains is measured as the market value (fair value) less book value (carrying value) o f the outstanding
financial instruments, including debt, investment securities and derivatives, scaled by book value o f total assets. The
independent variable - contract (notional) value o f derivatives is scaled by book value o f total assets. Table 6 entries
include the predicted sign, estimated parameter, standard error o f coefficient and t-test value.
Variable
Predicted Sign
Coef Estimated
S td E rr o fC o e f
t-test
Intercept
-0.0055
0.0014
-3.8631
Contract Value of Derivatives +
0.0049
0.0073
0.6696
R 2 is 0.0022, and F-test is 0.4484
94
T able 7
Regression Results
The sample contains 209 firms with fiscal year-end o f Dec., 1997 on the EDGAR database. The dependent
variable - realized losses is measured as the realized losses from the disposition o f the financial instruments, scaled by
book value o f total assets. The independent variable - contract (notional) value o f derivatives is scale by book value o f
total assets. Table 7 entries include the predicted sign, estimated parameter, standard error o f coefficient and t-test value.
V ariable
Predicted Sign
Coef Estim ated
S td E r r o f C o e f
t-test
Intercept
-0.0001
0.0004
-0.3203
Contract Value o f Derivatives +
0.0021
0.0020
1.0753
R 2 is 0.0056, and F-test is 1.1563.
95
a b
l e
Percent of Firms Realizing Losses/Gains

The sample contains 209 firms with fiscal end o f Dec., 1997 on the EDGAR database. Among these firms, 177
firms use derivatives, and 3 2 firms do not use derivatives at the fiscal end. However, among the firms that use derivatives,
6 firms have zero contract value o f derivatives, and 16 firms use derivatives with limited kinds and immaterial amount.
We exclude these firms from the sample.
Firms with Derivatives
Firms without Derivatives
N=155
N=32
Percent o f Firms Realize Losses
28.39%
12.00%
Percent o f Firms Realize Gains
18.06%
16.00%
Percent o f Firms Realize Neither
53.55%
72.00%
Total
100%
100%
96
Appendix A
From equation (4), (11) (12), and (13), we have
Y d(6) =min[F(0)tF +0(d )]
(6)
Y\Q ) =max{O,min(7(0) - 0 ( 6 ) -R,Q+F(6)]}
(11)
T'(0) =max{F[0)- [ * +>(0)] -[2+F(0)],O}

=V(6) -min(F(0),[F +>(0)] +\Q+F(6)\}
S+F+>=A|T *(0)+1^(0)
J(0)]
(12)
(13)
We want to prove S+F+D=V; i.e., Y d(6) +Yf(6 )+Y '(0)=V(6). Hence we want to prove
m in[F(0)^ +Z)(0)] +max(O^nin(F(0) -0 (6 ) -R,Q+F(6)}
+V(6) -min{F(0)f[F +D(0)]+[Q+F(0)]}=P(0)
This is equivalent to proving
min(F(0)^ +*0)] +max{Oqnin(F(0) -*0) -F,0+F(0)]}
=min(J/(0),[F+D(0)] +[Q+F(0)]>
There are three circumstances:
(1) F(6)<R+0(d):
then LHS= V(6) +0=V(6), and RHS=V(6).
(2) R +D(6)< V(6)<R+D(6)+Q+F(6) :
97
then LHS=R +D(6) * V(Q) -D(Q) - R =^(0), and RHS=V(Q).

(3) F(0) >R^D(Q)+Q+F(d):
then LHS=R+D(Q)+Q+F(Q), and RHS=R+D(B)+Q+F(0).

Therefore, we have T'rf(0)+2r/(0)+T''(0)=r(0), and thus:
S+F^D=A[T *(0)] +A[r'(0)] +A[T',(0)] =A[Yd(d) +1^(0)+r'(0)]
=A[V(Q)]-V
(by the linearity o f AQ )
98
Appendix B
since
S - N (S , a,2)
we have
(*-#
5
2a]
E[max(_S-Sfi)]= [(S-S)ftg)dS=
L
dS
L
(s-s?
S
2a]
- f( s - S -d i-(s -s )]
fa o ,
Let y=S-S, then

-Jil
[max(S-S,0)] = fy -^ -,d y
0
\J2 TZat
y jlK
Appendix C
Assuming
Pt = a xbvt + a 2x at + a 3T( + ( v u>v2, ,v 3, )J3

where a x, <X2 , a 2 and {$ =(J3X
(88)
,/?3) Tare to be determined.
We also have:
E"t
] = P FPt ~
[ d (^ ]
(89)
where d l+l = RFbvt - fcv,+1 + x a

t,M+ rT^
From (88) and (89), we have
RFPt - Et [RFbv{ - bvt+l + x,a+l + tTt^ a xEt [bvl+l]

+ a 2 E t l x ? + l ] + Z3E t [ T' +l ] + ^ r [ ( v lf+ l, v 2r+1, v 3f+l) / ? ]
(90)
That is
RF( a { - 1)bv( + a 2RFx at + a 3RFTt + RF(yu,v2l,v2t)0

= O i - l ) 'f [6v,+l] + (1 + a 2 ) E t [ x ^ ] + ( r + ar3) , [ 7 ; +l]
^ [O W ^ r+ l^ r+ lV ? ]
Using the dynamic linear information model, we have
R F{CCX 1) = (tZj 1)ty33 + ( 1 + # 2 ) ^ 1 2
100
(91)
R Fcc2 = ( 1 + #
&Fa ) =
r fA i
r f
2)^11
(r + &
i ) & 22
= YxPx + 1 + a r 2
r + a 3 + y 2/32
R f A 3 = <*i ~
+ Y 3A 3
Solving the equations,

RpO).,
a. = 1+ -----------11-------------(Rp ~
<^33
) ( R p ~ tû)
TCOn
R p ~ 22
r f
( R p Y x ) { RF ~ n )
tR f
( R P ~ Y 2 ) ( R P ~ 22 )
R F 12________________
(.Rp ~ Yi)(Rp ~
^(Rp ~ &u)
101
Appendix D
Replacing the two conditions into the maximization function, the maximization problem is
changed to:
min (x -X)(Gt -L l)+xRFl(G -G l -L +t)
Ignoring the fixed term G and L, the problem is simplified as:

min (x -k -x R Fl)(Gl -Lx)
subject to
0 <GX<G
0 <LX<L
So the solutions o f Gx andZj depend on the sign o f ( x -A.-xRFl ). If the sign is positive, to minimize
(x-A.-xRFl)(Gx-L x) , we should minimize GX~LX. That is, we should minimize the first period
earnings, xx. Then we get the optimal tax trading strategy of realizing losses and holding gains. If the
sign is negative, we get the strategy that opposes to the optimal tax-trading strategy. If x -X-xRFl =0,
then any strategy will do.
102
Appendix E
Assuming rfxl)=xl +^-e
To solve the minimization problem, we have:
k
df(xl)/dxl =1 ~ - e 'Xl -R p 1=0
o^ X jX ax^ -e 'Xl>0
So
that is
XRP
*,=ln-----
Subject to
-L<xxG
103
Graph 1
The financial reporting function: wt =-kxt
104
Graph 2
The solution o f earnings x depends on the value o f k:
Xi
105
Graph 3
The financial reporting cost function: wt =Xe Xf
106
Graph 4
The solution o f earnings x depends on the value o f A.
1/22
107
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113
Vita
Name:
Tao Zeng
Education:
Ph.D. candidate in Accountancy. Major field Accounting; minor field

Economics (September, 1994 -).
M.Econ., Dong Bei University o f Finance and Economics, P.R. China
(September, 1989 - July, 1992).
B.Econ., Dong Bei University o f Finance and Economics, P.R. China
(September, 1985 - July, 1989).
Academic Awards:
Wilfrid Laurier Institutional Fellowship 1998-2000

Social Science and Humanities Research Council o f Canada Doctoral
Fellowship (1997).
Queens Graduate Awards (1997,1996 & 1995).
American Accounting Association (AAA) Doctoral Consortium
Fellow (1996).
Morgan Brown Scholarship (1996).
R.Samuel Mclaughlin Fellowship (1995).
Queens Graduate Fellowship (1994).
Deans Awards (1994).
Publicans:
Accounting and Organization: A Case Study Using Structuration

Theory Advances o f Economics and Management, Dalian University
o f Technology Press, 161-183,1999.
The Adoption o f Western Accounting System and Accounting
Reform, China Foreign Trade Finance and Accounting, No.!, 1994.
GATT and Accounting System, China Foreign Trade Finance and
Accounting, No.7, 1993.
Financial Accounting Model o f Profit Prediction, Liaoning
Accounting, N o .l, 1992.
114
Papers for Conference:
Tax-Timing Option and Derivative Instruments has been accepted

for presenting at the ASAC-EFS AM 2000 Conference.
Accounting and Organization: A Case Study Using Structuration
Theory was presented at the 1999 International Conference on
Improving Management Through University-Industry Partnership.
The Origin and Development o f Accountancy Regulation in China
was accepted for presenting at the Second South China Symposium
Committee 1996.
Adoption o f Western Accounting System for Corporate Operation,
award on Seventh Northeast China Foreign Trade Symposium
Committee 1994, and award on Liaoning Province Foreign Trade
Accounting Association Symposium 1994.
Work under Review:
The Determinants o f Dividend Policy: A Canadian Evidence, first

review o f Public Finance Review .
T ax Planning and Derivatives Instruments, first review of
International Tax Journal.
T ax Effect on Finn Valuation Under Clean Surplus Accounting, first
review of Accounting and Business Research.
Taxpayers Tax and Financial Reporting Decisions and Auditing in
a Game Theoretical Model, First review o f Journal o f American
Taxation Association.
Research Interest:
Tax planning using financial instruments, the effect o f corporate

taxation on firm market valuation, international accounting.
Teaching Interest:
Taxation, Financial and M anagement Accounting, International

Accounting.
Experience:
Lecturer, Wilfrid Laurier University, July, 1998 - present.

Assistant Accountant, China Packaging Import & Export Liaoning Co.,
August, 1992 - August, 1994.
Assistant Auditor, Dalian Guang Hua Accounting Firm, November,
1989 - July, 1990.
115

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Chapter One: Introduction

Chapter Two: Literature Review

Chapter Three: Tax-Timing Option and Tax-Character

3.7.4 Summary and Limitation............................................................................................57

Chapter Four: Effect of Taxes on Firm Valuation Under

4.3 Tax-based Market Valuation Framework................................................................................. 62

4.3.1 Accounting Relations................................................................................................ ..

Chapter Five: Conclusion and Summary

1.1 Tax Consequences of Using Derivatives (Topic of Interest)

met (IRC Sec. 1222):

1.2 Contributions of the Thesis

1.3 Organization of the Thesis

property which has appreciated (referred to as cherry picking).

2.1.2 Theoretical Work Involving Tax-timing Options

2.1.3 Empirical Work Involving Tax-timing Options

2.2 Literature Related to Tax-character Issues

3.2 Valuation Framework

0: the states o f nature that can occur at time t+l

where A is the time-state-price integration operator, which is linear and positive.

The stockholders' claim will be:

Then, similar to Lewellen and Mauer (1988), we have:

The equity holders' claim will be:

F'C) =max{F(0) -[ +Z>(0)] ~[0+^l9)],O}

Using the linear operator, we have:

3.3 Security Holder Tax-timing Option

The time t value o f this tax option will be:

The time t value o f this tax-timing option will be:

The tax option of the bondholders at time t will be:

The time t value of this tax option will be:

Based on the above formulations, we now arrive at the following proposition:

Z F(0) =F-max{O^nin(PX0) -D (0 ) - , 0 +F(0 )]}

Z D(Q) =D-miii[V(Q)yR +>(0)]

From appendix A, we will have:

By the convexity o f the max{.,.} function, we have:

with the inequality holding strictly unless:

F [Z F(0 )X )|Z D(0)X)] ^ Z ^ O J X J I Z ^ O ) * ) ] =1

F[Z s(d)X) IZ F(0)X)] =F[Z F(d}> 0 1Z 5(0)>O]=1

for all 0, where F(. | .) denotes conditional probability.

3.4 An Illustrative Example.

d =C^)^[max(5-1Sr,0)] +[max(> -AO)]}

with D > > aD

V~ N(Vt o2y ), . with

2coviV, D ), and S=V-D . We also assume S > > as to avoid the

possibility that S can be negative.

Since they swap equity for these other instruments.

Assume F are normally distributed as F~N(F,a%), with F > > op .

Under the normality assumptions (see appendix B),

$ =(r )[o1y '+oo '+af]l/*(0)]

=(t){[o l+ o l-2 c o ^ J r )]l/2+oD+o^\f'(p)]

= (r){[o^aJ-2p(S r/ ) o so/r]ly2+oF- a5}l/'( 0)]

1. That is xta{xt-TQcr T )-T :T y iR F-l)b v t_l .