A Belgian bank holds eur 10 billion worth of seven-year eur government bonds, with a direct yield of 10 percent (that is, its annual interest income is eur 1b).
(a) Until a tax reform in 1992, the bank could transform its interest income into dividend income, which enjoyed a 90 percent exclusion privilege. Specifically, the bank sold its bonds to a Dublin dock company (DDC), which was fully owned by an Irish holding company (IHC), which in turn was fully owned by the Belgian bank (BB). Interest income received by the DDC was taxed at 10 percent, and then paid out as a dividend to IHC, which did not pay any taxes (100 percent exclusion within Ireland). IHC then paid the dividend to its owner, BB. Assume no withholding tax between Belgium and Ireland, and a 90 percent dividend exclusion and a 40 percent corporate tax rate in Belgium. What was the annual tax gain?
(b) A tax consultant suggested that BB would gain even more by swapping its seven-year, 10 percent eur bonds into nzd, which at that time yielded 20 percent. Thus, the consultant argued, the gains would be doubled. What crucial feature is overlooked in this argument?