This chapter is about the taxation of bonds in the United States. I'm sure you already appreciate that taxes are very important in financial analysis. After all, the after-tax rate of return is what ultimately matters to an investor and the after-tax cost of funds is what matters to a borrower. But please fight the temptation to think that taxation is boring and just a matter of learning a set of rules. I hope to demonstrate that there are some interesting questions regarding taxation both in theory and in practice, as well as some very useful bond math calculations.
Discussions about taxation commonly involve four aspects of a cash flow, or accrual:
1. Source. Is the income/expense domestic or foreign?
2. Timing. Is the income/expense current or deferred?
3. Character. Is the cash flow ordinary income/expense or a capital gain/ loss?
4. Exemption. Is the ordinary income or capital gain exempt from taxation?
There are different tax rules and rates depending on the source, timing, character, and exemption status of the cash flow. I limit the discussion here to U.S. investors in U.S. bonds. Therefore, the source of the cash flow is not a factor, but the timing, character, and exemption status are in the mix.
We consider these questions: What is the difference between interest income and a capital gain for tax purposes? How and when should the implicit interest income on a zero-coupon bond be taxed? How should we compare investments in fully taxable corporate bonds and tax-exempt municipal bonds? How should projected after-tax rates of return on corporate bonds be calculated? This last question is particularly relevant. I argue that the after-tax rate on some bonds trading at a discount displayed on the widely used Bloomberg Yield and Spread Analysis page is misleading to U.S. investors, and probably has been so for the past 30 years.
Getting taxes correct is not easy, as some high-ranking U.S. government officials surely will attest. Let me be clear about this: I am not a tax attorney; I am a college professor. What I know about bond taxation comes from my reading of Internal Revenue Service (IRS) Publication 550 on Investment Income and Expenses. Some aspects of U.S. tax rules make sense to me, some make no sense at all, some are just too detailed for me to try to figure out. I aim in this chapter to target those aspects that are most relevant to the study of bond math.