Financial fiction - How to make money: Belgian capital gain tax version
Everybody is familiar with the option exercise mechanism ... expect fictional Belgian lawmakers.
A (real) judge once said: "it is not illegal to be smarter than tax collectors". To be precise, what he actually said, was "It is not illegal to be smarter than your counterparties [...]", but in tax matters, the tax collector is your counterparty.
What we explore in this financial fiction blog, is to assess if it is possible to make money out of the ignorance of fictional lawmakers.
This is a work of fiction. Characters, places, and events are products of the author’s imagination. Any likeness to real people, living or dead, or actual events is by chance almost everywhere.(1) This blog does not contain any financial or tax advice.
The taxation of options is done in the following way: if an option is bought then sold or the opposite, the profit or loss on the buy/sell is taxable. If an option is exercised, the option price is ignored for tax purposes, but the transaction on the underlying is taxed as if the trade on the underlying was done at the strike price. The profits and losses of different transactions are netted. If the total is a profit, there is a tax (10%), if the total is a loss, no tax is due and the loss can be used only to offset other capital gains in the same year — not other revenue or gain in other years.
We start with an option, for example a put with strike K and expiry T on an underlying with value St at time t; the put's value is denoted Pt.
At the same time and at the same price we buy and sell such an option. We do so with two different counterparties in such a way that the options are not fungible. At expiry (or one instant before if needed) we do the following.
In all cases, sell back the option we bought just one instant before expiry and we let the option we sold expire.
If the option is in-the-money, i.e. ST ≤ K, For the expired option, we need to buy the stock in the market at ST and give it at expiry for the price K. In economical terms, the profit is PT - P0 ~ (K-ST) - P0 for the option we bought and we have -(K-ST) + 0 + P0 for the option we sold. A total, as expected, of 0.
In tax terms , the option we sold expires and its price is not taken into account. The profit on the underlying is -(K - ST) < 0, i.e. a loss. On the other option, the buy and sell is taken into account and the total amount (K-ST) - P0 is recorded as a profit. After netting the total taxable profit is -(K - ST) + (K-ST) - P0 = -P0.
If the option is out-of-the-money, i.e. ST > K, we use the same strategy. As the option we sold expires worthless, there is no need to buy the underlying in the market. The economical profit for the option expired is -PT- (-P0) = 0+P0 = P0. For the other option the profit is PT-P0 = -P0. A total, as expected, of 0.
In tax terms , the option we sold expires worthless and its price is not taken into account. On the other option, the buy and sell is taken into account and the total amount (PT) - P0 ~ -P0 is recorded as a profit. After netting the total taxable profit is 0 - P0 = -P0.
As options always have a positive value, a taxable profit of -P0, i.e. a loss, is incurred without economical loss. A fictional synthetic tax-loss harvesting!
The initial claim of this fiction was slightly exaggerated, it does not explain how to make fictional money, it explains how to generate fictional synthetic tax-losses. Those losses can cover any real gain. At the end, you pay your fair share of fictional tax as decided by fictional lawmakers by not paying any. In reality, nobody would be ignorant enough to create such a tax mechanism, it can appear only in fairy tales.
(1) Probability measure associated with this statement not provided.
Outside of fiction, you can always contact me through muRisQ for advice about quantitative finance, including on how to create meaningful regulations.
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