Participation exemption and tax arbitrage: Italy’s case

Abstract

This paper studies how participation exemption (PEX) tax rules for stocks owned by companies, which are frequent in EU countries, introduce tax arbitrage opportunities. The focus is on Italy’s PEX rules. PEX enables companies to make manufactured loans that generate tax exempt interest income by combining stocks with forwards or options. Borrowing through similar manufactured loans allows companies to bypass restrictions to deducting the cost of borrowing. PEX induced arbitrage exploitable through stock and options portfolios is available even when put-call parity holds for European options. Derivatives that hedge a stock can “inherit” the PEX regime of the stock they hedge. PEX gives companies that own a stock a tax timing option, which can be exploited through stock straddle strategies, i.e. long-short positions in the same stock, and which can generate valuable tax savings.

Appendix: the present value of the arbitrage profit as per strategy B

We notice that under the assumptions of Eqs. 13 and 15, and again assuming that $S_{T} \simeq S_{{T^{ - } }}$ and $T \simeq T^{ - } ,$ and under the assumptions of Eqs. 12 and 14, the time t present value of $\tau \cdot \max \left( {S_{{T^{ - } }} - S_{t} ,0} \right),$ i.e. the arbitrage profit as per strategy B in the text, is

$$ \tau \cdot S_{t} e^{{r\tau \left( {T - t} \right)}} \cdot N\left( {{\frac{{\left( {r + {\tfrac{1}{2}}\sigma^{2} } \right)\left( {T - t} \right)}}{{\sigma \sqrt {T - t} }}}} \right) - \tau \cdot e^{{ - r\left( {1 - \tau } \right)\left( {T - t} \right)}} \cdot S_{t} \cdot N\left( {{\frac{{\left( {r - {\tfrac{1}{2}}\sigma^{2} } \right)\left( {T - t} \right)}}{{\sigma \sqrt {T - t} }}}} \right) $$

(29)

with $N(x) = \int_{ - \infty }^{x} {{\tfrac{1}{{\sqrt {2\pi } }}}e^{{ - {\tfrac{{u^{2} }}{2}}}} du} .$