A withholding tax is a tax imposed by a country on interest or dividends to be paid to foreign (i.e., nonresident) investors who have purchased securities in that country. Foreign investors, of course, want to avoid withholding taxes. The ex- cerpt below discussing withholding taxes is taken from the International Capital Market in 1989 published by the European Investment Bank: During 1989 changes in withholding tax regimes-actual and proposed- made for additional gyrations in securities prices. Speculation as to the permanence of the 10% withholding tax on coupon income of all comes- tically issued bonds in Germany was already alive when it was introduced on January 1, 1989. When the decision was finally taken in May to abolish the tax as from July 1, yield relations between the Euro- deutschemark and the domestic markets had already begun to change. Yields on Euro-deutschemark bonds by supranational borrowers, for in- stance, which had traded below German government bonds (Bunds), started to rise in early April and returned to their traditional level above those of Bunds. Issuing patterns also fell back to those of the pre-with- holding tax period: German entities reduced sharply their issuing activity in the Euromarket. The heavy outflow of long-term funds from Germany that had preceded the introduction of the withholding tax was also partly reversed.

a. What is a Euro-deutschemark bond?

b. Why would proposed withholding taxes cause gyrations in securities prices?

c. Explain why imposition of the German 10% withholding tax in January 1989 caused yields on Euro-deutschemark bonds issued by supranational borrowers to trade at a lower yield than German government bonds.

d. Why did issuing patterns fall back to those of the pre-withholding tax period?AppendixLO1