238  锟0/span>  (2002) vol. 50, no 1 Making the Line a Gap: Edgar's Treatment of the Debt-Equity Boundary Gordon Longhouse* KEYWORDS: CAPITAL MARKETS 锟0/span> CORPORATE FINANCE 锟0/span> DEBT EQUITY 锟0/span> EQUITY FINANCE 锟0/span> INTEREST DEDUCTIBILITY 锟0/span> VENTURE CAPITAL INTRODUCTION This article examines the argument made by Tim Edgar in his book The Income Tax Treatment of Financial Instruments: Theory and Practice1 concerning the correct tax treatment of debt-equity hybrid instruments.2 After a brief examination of Edgar's discussion, the article takes up the argument     that the premise upon which Edgar based his argument00hat hybrids are primarily arbitrage-driven00s unsound. I contend that Edgar's proposal to employ an American-style "facts and circumstances" approach to the distinction is not the first "second-best" solution to the genuine problems posed to a comprehensive income tax system by the existence of hybrid securities. It ought to be possible, in the context of a corporate tax system that features shareholder-level dividend tax relief, to propose a system to distinguish debt from equity that, while admitting some economic efficiency loss, gives greater certainty for less compliance cost than the "factors" approach proposed by Edgar. *Technical Leader, Financial Services Industry Group, Large Business & International Business Line, Australian Taxation Office, Melbourne. An earlier draft of this article was reviewed by Dr. Timothy Rumble of the Savings Factory, Mr. Michael E. Todd of the Large and Medium Enterprise segment of the Internal Revenue Service, and Ms. Valerie Chambers. Comments were gratefully received and changes were made. This article would not have been possible were it not for the efforts of Ms. Stephanie Long, Senior Tax Counsel at the Australian Taxation Office. Stephanie fossicks through the database of the Social Science Research Network and brings articles that might be of interest to her colleagues to our attention. Many of those articles were used in this comment. All of the above assistance is gratefully acknowledged. This article is the work of the author and does not reflect the views of the Australian Taxation Office and certainly not the views of any of its reviewers. making the line a gap: edgar's treatment of the debt-equity boundary锟0239 EDGAR'S ARGUMENT Edgar argues that, while corporate-level taxation is a necessary and desirable part of his proposed system of "expected-return" taxation of income, it is not possible to distinguish accurately between "interest" (service payments on debt instruments that fall outside the corporate tax base) and "dividends" (service payments on equity that are seen as distributions of the corporate tax base).3 He goes on to argue that the major and dominant purpose behind the development of hybrids is tax and regulatory       arbitrage. "It is," he says, "unclear, however, whether much if any genuine innovation can be attributed to the development of hybrid instruments."4 From this basis, he argues in favour of the "facts and circumstances" approach that is currently in use in the United States to distinguish debt from equity.5 Under the "factors" approach, as he terms it, the courts and administrators abstract from a hybrid those characteristics that give it an equity-like appearance and those that give it a debt-like appearance, weigh them up, and, without applying any articulated principle, reach a verdict on the hybrid's correct tax treatment. Although he acknowledges      the costs in uncertainty and difficulty of administering such a system, Edgar argues in its favour on the grounds that it tends to suppress sharp discontinuities at the debt-equity boundary by avoiding the creation of a sharp boundary.6 Issuers, who might otherwise be motivated to issue substitutable instruments, may be deterred from doing so by the risk of after-issue examination of the instrument by the fiscal authorities and the subsequent denial of tax benefits. In contrast to his proposed treatment of debt-equity hybrids is Edgar's treatment of the threat posed the tax system by "straddle" transactions that seek to shift income between tax years.7 A taxpayer can implement a straddle by engaging in two transactions        that are taxed on realization and economically offset (as one transaction becomes more valuable, the other becomes less so). By realizing one or the other of the transactions toward the end of the tax year, the taxpayer can effectively move taxable income forward or back a year. This technique sometimes comes as a prepackaged         structured transaction that can be purchased "off the shelf." Although a straddle is often a transparent tax-avoidance device, Edgar would not use a factors approach to the question of when to integrate the two legs of a straddle into a single transaction for tax purposes to nullify the income-shifting effect. The reason for this is that the uncertainties surrounding a factors approach to straddles would interfere with legitimate hedge transactions. Instead of the factors     approach, he calls for detailed legislative tax rules to treat the risk. He expects that the intention of these rules will be avoided from time to time and that they would have to be modified to preserve the revenue. To put it in other words (not Edgar's), a straddle is an abuse of an otherwise legitimate technique productive of public benefits, while debt-equity hybrids are tax-motivated instruments with little or no legitimate commercial utility and consequently little or no public benefit.8 From this, it follows that straddles ought to be remedied by legislation to give the market certainty, while the debt-equity borderline should be patrolled by administrative        action in order to deliberately leave the market uncertain. 240  锟0/span>  canadian tax journal/revue fiscale canadienne (2002) vol. 50, no 1 The next two sections of this article discuss the issue of arbitrage and explore the role that hybrids play in it and then give an example of what I consider to be an innovative and publicly useful sort of debt-equity hybrid. The fact that hybrid and exotic capital securities have been and, no doubt, are being used to arbitrage the tax system and that most discussion of the topic has, until recently, been tax-centred has obscured the genuine commercial role that hybrids can play in the allocation of risk inherent in investing in an enterprise. HYBRID ARBITRAGE Although it is true that hybrid debt-equity securities can be used for arbitrage, it is going too far to argue that all or substantially all such arbitrage is sourced in or at the expense of the tax system.9 The worldwide phenomenon of bank "tier 1" hybrid instruments that resulted from the Bank of International Settlements 1988 Accord on regulatory bank capital ("the Basle accord") demonstrates a considerable number of incongruencies in the market for these securities. The claim that some make for a deduction of coupons from taxable profits is only one of these. Without going into the gritty details, the Basle accord is an attempt by industry and regulators to devise a set of international standards for the prudential regulation of banks. In the absence of regulation, a bank seeking to maximize returns to its shareholders has an incentive to maximize risk. This is because company limited liability limits shareholder loss while offering shareholders unlimited profit from risk taking. In contrast, bank depositors and creditors are limited in respect of both losses and gains. It is therefore in the interests of shareholders that creditors be put at maximum risk since creditors share potential losses but get little or none of the potential gains that come from risk. Competitive capital markets put pressure on the more prudent to become less prudent, potentially increasing risk throughout the payments system. This could have catastrophic results for the global economy. The Basle accord seeks to ameliorate this risk by having central banks agree, among other things, to impose on their resident banks certain minimum capital standards. These standards require of banks that they maintain a certain amount of capital capable of absorbing losses without threatening the continued existence of the institution. The very best, and the most expensive, of this capital is referred to as "tier 1 capital." Tier 1 capital consists basically of shareholder funds, retained earnings, and loss reserves. The 1988 Basle accord permits banks to include within their tier 1 capital (to a maximum of 15 percent) hybrid instruments that meet certain criteria. To be eligible for tier 1 treatment, instruments must 锟0/span> possess permanency of capital, 锟0/span> are deeply subordinated, 锟0/span> are fully paid, 锟0/span> are non-cumulative, and 锟0/span> pay distributions from earnings at the issuer's discretion.10 making the line a gap: edgar's treatment of the debt-equity boundary  锟0/span>  241 In an effort to meet these criteria, banks and other financial institutions have issued an array of perpetual, non-cumulative, fixed-rate hybrid instruments, some of dazzling      complexity.11 Instruments issued by Australian institutions often feature floating-rate service payments that are conditional on current-year profitability and subordinated to all other creditors except ordinary shareholders. Failure to pay service costs will usually result in the cancellation of the note and the issue of a prepaid share (ordinary or convertible preference share) in its stead.12 Shareholders may not be paid dividends until service payments to the hybrid resume. The only "debt-like" features of these hybrids are the regular and fixed nature of the service payments and the fact that they offer little or no capital appreciation. They appear to offer almost all of the downside risk of equity for relatively little compensation. Nevertheless, many of these instruments have been purchased and supported by the retail market ("mums and dads") who, trusting the "brand" of the issuer, buy them as a substitute for government debt and bank deposits. Some issuers have sought and obtained a credit rating.13 This is intriguing because failure to pay the service costs of the instrument is often not a default and, when it is, the only remedy available to the investor is to become a shareholder of the issuer. The ratings agencies nevertheless intend to treat a failure to pay service costs as a default. Says Standard & Poor's: "[I]nvestment grade issuers are expected to meet all financial obligations in a timely manner, and... fixed income investors expect ongoing coupon payments to be met."14 The result is an instrument that behaves very much like debt so long as the company is a going concern but becomes equity should the company go into liquidation. The fact that the market treats these instruments as debt, in spite of their deep subordination in the company capital structure and the discretionary nature of the coupon, seems to suggest that the Basle accord requires that well-run banks keep more capital than the market believes is necessary. 15 If this is the case, the rationale may be one of ordinary conservatism or it may be because the risks against which capital is measured are solely credit risk of bank customers and market risk on banks' proprietary trading. These are thought to make up only half of the measurable risk of operating a bank. Excess capital may be a form of insurance against risks as yet unmeasured and unregulated. Permitting banks to issue cheaper hybrids is a way of making the excessive capital requirements of the regulators more tolerable to the affected institutions. Permitting banks to issue some of their capital in the form of hybrids reduces the cost of this capital substantially. 16 Often, a bank will issue the hybrid and return the proceeds of the issue to shareholders as capital. One would expect the shareholders to reinvest the capital returned to them elsewhere in the equity markets.      To the extent that this in fact takes place, hybrids enable capital markets to put capital to its highest and best use. That is to say, "high-risk capital" is redeployed away from industries where it is needed less and toward industries where it is needed more. Hybrids might also be useful as an indicator that a company is taking on too much risk. As argued above, shareholders have an incentive to have the company 242  锟0/span>  canadian tax journal/revue fiscale canadienne (2002) vol. 50, no 1 assume risk to the point that creditors are substantially at risk, because creditors do not share in the benefits of risk, only in the hazards. The same is also true of fixed- income hybrids. The difference between the situations is that hybrid investors are subordinated to creditors. It has been suggested that subordinated-debt investors should have the incentive to keep a closer watch on a company's risk-taking behaviour     than ordinary creditors. From this it ought to follow that a declining market price for subordinated fixed-interest securities could be used as an early sign to rating and regulatory agencies that a company is hazarding its creditors.17 One cannot help but get the impression that somebody involved in this market00he        regulators, the issuers, or the investors00s kidding themselves about what these instruments are and what they are supposed to be doing. Judging from the empirical evidence so far, these instruments do not fill the role they were expected to, that of absorbing losses while maintaining the company as a going concern.18 While this is not sufficient reason for the tax system to be especially favourable tothe existence of such securities, neither is it reason for the tax system to erect compliance-cost barriers to them. If, however, hybrids offered some utility to investors     in the management of the risk of investment, perhaps a more benign tax treatment for them would be in order. INNOVATION The single-axis spectrum of time-value return versus contingent-value return that is generally employed to distinguish debt from equity can often be a barrier to understanding debt-equity hybrids. An example in which this is the case can be found in the convertible preferred instruments used by venture capitalists. People considering investing in startup or other particularly risky company situations        face challenges of illiquidity and information shortfall that other investors have sought to avoid with traditional market structures. To alleviate these difficulties,         venture capitalists have created what I would consider innovative hybrid structures. In an article in which they take up the brief for convertible notes, Brenner and Schwartz argue that convertible notes are valuable to risky companies. This is because of the relative insensitivity of [the bond's] value to the risk of the issuing company. This insensitivity makes it easier for the bond issuer and purchaser to agree on the value of the bond00ven when they disagree on the risk of the company00nd thus to come to terms. It also protects the bondholder against adverse consequences of management policies which would increase the risk of the company.19 A convertible note (bond) is a debt instrument that has stapled to it an option, usually a call option, in favour of the investor over ordinary company shares. In the event of conversion, the face value of the note funds the acquisition of shares in the issuing company. The hybrid's relative insensitivity to risk is a result of what may be termed the "hedge effect" of combining an option with a note. If the company making the line a gap: edgar's treatment of the debt-equity boundary  锟0/span>  243 isriskier than expected, then the option portion of the hybrid gains value as the note portion loses value. Conversely, if the company turns out to be less risky than expected, the note can be expected to gain value as the option loses value. The inverse correlation will not be exact but it ought to be sufficient to moderate some of the volatility of investments in risky situations.20 Application of this theory can be seen in the structures employed by venture capitalists to finance risky startup companies. Such financing faces a number of challenges that are usually mitigated in other investment situations:21 1. Venture capital ( VC ) financiers must seek a return commensurate with the risks they assume but, at the same time, they must not reduce the entrepreneur's       incentive to work and grow the business by seeking too great a share of the success of the enterprise. 2. VC financiers must be in a position to intervene directly in the management of the company in the event that the investment disappoints or threatens an outright loss. The temptation on the part of the entrepreneur to load the venture capitalist with unacceptable risk should be checked. 3. The VC financier and the entrepreneur will often have difficulty putting a value on assets (especially intangible assets) with neither historical cash flows nor liquid market comparative prices from which to work. A hybrid convertible note can often be used to alleviate these problems by making the conversion ratio (the number of shares into which the note will convert) dependent upon the performance of the company.22 Termed the "ratchet" convertible,      the security features an option that converts into a declining ratio of company shares as the rate of return on the investment exceeds a certain ceiling, or converts into an ever greater number of company shares as the investor's rate of return falls below a given floor. The note will often be designed so that, if the investor's rate of return falls to zero, the VC investor will end up with sufficient shares to take control of the company. Compared with the return on a convertible note with a fixed rate of conversion, the return on a ratchet convertible is less exposed to the fortunes of the company: it pays more than a fixed-rate convertible in respect of a less successful company but less than a fixed-rate convertible in respect of a company that is very successful. The entrepreneur is given ever-increasing upside incentive, the VC investor is given downside protection, and the value of intangible property in the company is effectively       determined in hindsight rather than forecast at the outset of the transaction. This is an example of how a difficult problem of conflicting interests between parties aggravated by imperfect information can be addressed using a debt-equity hybrid. One hybrid does not justify the entire market, but it does suggest that there is more to the market than arbitrage. While the government must get its share of revenue from investments, it should seek to avoid imposing unnecessary compliance burdens on those investments. Edgar argues that the factors approach is a necessary compliance burden if arbitrage along the borderline is to be avoided. I submit that, 244  锟0/span>  canadian tax journal/revue fiscale canadienne (2002) vol. 50, no 1 theoretically at least, it is possible to address the problems identified by Edgar while giving financial markets a fair degree of certainty in the design of capital instruments. SOME FEATURES OF A SYSTEM TO DISTINGUISH DEBT FROM EQUITY To begin with, Edgar is correct in seeing the need for some form of shareholder- level dividend tax relief to narrow the difference between the after-tax cost of debt and equity finance.23 Canada currently grants a tax credit toward the shareholder's final tax bill in respect of dividends received from Canadian-resident companies. Australia employs an imputation system whereby tax paid at the company level is "imputed" to shareholders by way of tax credits that attach to distributions to shareholders. The Australian system is more targeted and precise than the Canadian in that the shareholder tax credit is available only if the company has paid tax. This precision comes at the cost of complexity. Even without a form of shareholder tax relief, the gap between the relative cost of equity and debt is narrowed by the fact that equity interests00elative to debt interests00ay more of their returns as capital gains that are taxed on realization, whereas the returns to investors on almost all debt interests are distributed and taxed annually.24 Thus, equity will often have a tax advantage because some or all of the gain on equity interests is tax-deferred, in part because the value that the market puts on a share is a product of the share's anticipated and unrealized cash flow. Finally, the fact that Canada, Australia, and the United States grant some form of tax concession to income from realized capital gains benefits equity holders over debt holders since, as argued above, debt holders are unlikely to see an accrual of capital value on their investments. All of these factors, taken together, mean that, for a company, the after-tax cost difference between financing by way of equity and financing by way of debt is not as great (in tax systems that feature shareholder dividend relief) as might be expected at first glance. Nevertheless, some gap probably remains25 and, as Edgar argues, "[w]here the particular debt and equity instruments are perfect or nearly perfect substitutes, issuers and investors can engage in pure tax avoidance with little or no sacrifice in the pattern of associated cash flows."26 This is true, but if the problem is one of near substitutes not receiving identical tax treatment, the answer is to ensure that this does not take place. This can be done in a system that grants shareholder-level dividend tax relief and, where instruments are not bifurcated to determine tax treatment, by creating a value gap between those instruments that are entitled to equity benefits and those that are entitled to debt benefits. Edgar describes how the US Treasury, in pursuance of power granted by Congress      a decade before, proposed regulations that would grant debt treatment to those hybrid instruments whose value of expected returns equalled 50 percent of the value of the instrument overall. Investment bankers designed a convertible note that met the test exactly, whereupon the proposed regulations were promptly withdrawn.27 I suggest that a system along the lines proposed in those regulations could have been made workable if two further criteria had been met: making the line a gap: edgar's treatment of the debt-equity boundary  锟0/span>  245 1. a system of shareholder-level dividend tax relief to reduce the tax cost of equity so as to bring it closer to debt, and 2. a design feature to ensure that there is a value gap between those instruments      entitled to equity tax benefits and those entitled to debt tax benefits. To develop the second point further, distributions on an instrument would not be deductible from the company tax base unless the present value at issuance of theinstrument's expected returns exceeded, say, 55 percent of the instrument's total value. However, an instrument would not be entitled to equity tax benefits00/span> shareholder-level dividend tax relief and relief from cascading company tax28 00f itsexpected returns exceeded, say, 45 percent of the instrument's overall value.29 Distributions on those instruments that fell within the 55-45 percent gap would be neither deductible to the company nor eligible for dividend tax relief. Under such a system, one would expect instrument issuers to design hybrids so that they would get one form or another of favourable tax treatment. The result of such a system ought to be that no instrument receiving debt-tax treatment will be a near substitute for an instrument receiving equity-tax treatment. There would be efficiency loss in such a system to the extent that the opportunity to issue instruments within the "gap" is lost because of their comparative after-tax cost. In return for this loss of efficiency, issuers and their advisers would obtain certainty of tax treatment and savings in compliance costs to the extent that specialist    advisers would no longer be needed by industry or the fisc to manage this area of the system. One could anticipate that such a system would encourage legitimate risk allocation among capital providers through innovative instrument design. CONCLUSION I have spent a good part of this article arguing, first, that one of the premises fromwhich Edgar's argument proceeds00hat debt-equity hybrids are primarily tax-arbitrage-driven00s unsound and, second, that the conclusion he draws00hat the factors approach is the first second-best method of distinguishing debt from equity00oes not necessarily follow from his argument. Much of the tax literature dealing with debt-equity hybrids originates in the United States where the absence of shareholder-level dividend tax relief has created a rich tradition of employing hybrids for tax-arbitrage purposes.30 A great deal of that commentary cannot be profitably employed in the context of a system that grants relief at the shareholder level. In the system I have proposed, the absence of shareholder tax relief means that the debt-equity border has been moved from 50 percent, as it was under the proposed regulations, to 55 percent. This proposal would merely shift the boundary around which near substitutes would be created. To create a gap that would discourage arbitrage opportunities, there must be a valuable tax benefit granted to a sizable portion of the investment community to invest in tax equity. The system I have suggested as a substitute for the factors approach has been pitched at a conceptual level. There were a great many other difficulties with the 246  锟0/span>  canadian tax journal/revue fiscale canadienne (2002) vol. 50, no 1 system proposed by the US Treasury besides the choice of value to qualify for debt treatment and I would not suggest the use of such a system even with a system of dividend tax relief.31 The main point I have tried to make is that certainty could be conceivably granted to issuers and taxpayers without the expense in compliance costs and economic inefficiency of the factors approach. I close by noting, first, that it was reading Edgar's discussion of hybrids that inspired me to look into the literature on capital management and hybrids to discover      more precisely what, if any, were the commercial factors that drove the issue of hybrids and, second, that whatever its shortcomings, Edgar's discussion of the topic, by concentrating on the cash flows of the instruments themselves in the context of company tax and the taxation of financial instruments in general, is an advance on what has been written before and should be required reading for anyone interested in the topic. NOTES 1Tim Edgar, The Income Tax Treatment of Financial Instruments: Theory and Practice , Canadian Tax Paper no. 105 (Toronto: Canadian Tax Foundation, 2000) (herein referred to as "Edgar"). 2Herein referred to as "hybrids." In his book, Edgar uses the term "hybrid" to refer to instruments that contain both an expected-value element and a contingent-value element. This article does not discuss such instruments. 3Edgar, supra note 1, at 39-53 and 91-101. 4Ibid., at 310. Edgar's argument can be found at 304-11. 5IRS Notice 94-47, 1994-1 CB 357 and IRS Notice 94-48, 1994-1 CB 357 are examples of the current approach taken by the Internal Revenue Service (IRS) to "facts and circumstances." 6Edgar, supra note 1, at 307. 7Ibid., at 342-48. 8Compare Edgar at 348 with Edgar at 310, ibid. 9Hybrid instruments and exotic capital structures have been used to avoid estate and capital gains taxation. These structures have been efficient mainly because of design flaws in the taxation system. See Gordon Longhouse, "Policy, Pragmatism and the Taxation of Share Value Shifts" (1998) vol. 27, no. 1 Australian Tax Review 4-13. 10The accord and supporting materials can be found at the Web site of the Bank of International Settlements (BIS), http://www.bis.org/publ/bcbsca.htm. 11The US law firm of Brown & Wood (now Sidley, Austin, Brown & Wood LLP, Web site at http://www.sidley.com) published what amounts to a catalogue of tier 1 capital instruments that have been issued worldwide entitled "Preferred and Capital Product Development Focusing on Tier 1 Capital Products" (New York, February 2001). For sheer, mind-numbing complexity, it is difficult to beat the Australian TruePrs described at 81-82 or the Ex-Caps described at 27-29. 12The requirements that the instrument be in the form of a share or convertible into a share and that service costs be paid from current-year earnings were added to the BIS requirements by the Australian Prudential Regulatory Agency. 13Standard & Poor's, "Hybrid/Income Securities-Major Challenges of Investors" (December 1999), 2, lists some hybrids that obtained a rating. 14Standard & Poor's, "Australian and New Zealand Hybrid Securities00quity or Camouflaged Debt?" Ratings Commentary , May 30, 2001, 3. Available on the Web at http:// www.standardandpoors.com/australiaNZ/forum/marketcommentary/articles/com_photo.html. making the line a gap: edgar's treatment of the debt-equity boundary  锟0/span>  247 15"Banks issue hybrids because regulators and ratings agencies require capital levels higher than economically warranted": W.P. Hogan, "A Perspective on the Domestic and International Pressures Influencing the Operations of International Banks," paper presented to the Australian Taxation Office Workshop on the Taxation of Branches of International Banks, Sydney, March 20-21, 2001, 6. 16Standard & Poor's, supra note 14, at 1, notes that Australian bank-issued hybrids remain attractive to issuers in spite of the denial of deductibility of coupons by the Australia Taxation Office. 17See James Smalhout, "Can Subordinated Debt Call the Shots?" [April 2000] issue no. 372 Euromoney 144-46. 18IRS PLR 9910046, November 16, 1998, stated that a species of hybrid termed a "trust preferred security" ought to be treated as debt. These securities feature a long-term subordinated loan (30-plus years) plus an option on the part of the issuer to borrow interest payments for 6 or 7 years at the same rate of interest as on the principal. Alas, the existence of the instrument that provoked the letter ruling has not, as yet, assisted Enron Corporation out of its current difficulties. See L. Collins, "High Anxiety as Enron Slides," Australian Financial Review , November 30, 2001, 1. 19M.J. Brenner and E.S. Schwartz, "The Case for Convertibles" (1982) vol. 1, no. 3 Chase Financial Quarterly 27-46, at 28. 20The inverse correlation will not be exact because changes to the yield curve for debt need not correlate to changes to the variables that go into pricing an option. 21The discussion that follows is based mostly on Douglas Cumming, The Convertible Preferred Equity Puzzle in Canadian Venture Capital Finance , University of Alberta Working Paper (Edmonton: University of Alberta, November 2001) and Michael Klausner and Kate Litvak, What Economists Have Taught Us About Venture Capital Financing , Stanford Law and Economics Olin Working Paper no. 221 (Stanford, CA: Stanford Law School, John M. Olin Program in Law and Economics, July 2001), both of which can be found by searching the Social Science Research Network at http://www.ssrn.com. 22M. Traill (Macquarie Bank), "Capital Management in Private Equity Markets," paper presented to the Share Buyback & Capital Management Summit, July 24-25, 2001, Hotel Intercontinental, Sydney. 23Edgar, supra note 1, at 35. 24Compared with Australian companies, American companies seem to pay less of their profits to shareholders as dividends, perhaps as a result of this tax treatment. If this is the case, it would have the effect of lowering the cost of equity00s shareholders get full use of the deferral advantage00ut at a potential cost of entrapping capital in traditional companies comparatively less able than emerging companies to use capital to profitable advantage. The lack of dividend tax relief creates a tax bias toward leaving the decision to reinvest profits with company management rather than with financial markets. Shareholders face an agency cost in this situation since management may not put the retained capital to its highest and best use. See J. Clements, "Dividends Sacrificed on the Altar of Growth," Australian Financial Review , October 31, 2001, 22 and, on the relative ability of capital markets and company management to allocate capital, see Bengt Holmstrom and S.N. Kaplan, Corporate Governance and Merger Activity in the US: Making Sense of the 1980s and 1990s , MIT Department of Economics Working Paper no. 01-11 (Cambridge, MA: Massachusetts Institute of Technology, Department of Economics, February 2001). 25Edgar, supra note 1, at 95. But see Grant Richardson and Roman Lanis, "The Influence of Income Taxes on the Use of Debt Held by Publicly Listed Australian Corporations" (2001) vol. 16, no. 1 Australian Tax Forum 3-31, where the authors argue that dividend imputation has entirely neutralized the tax advantage of debt. 248  锟0/span>  canadian tax journal/revue fiscale canadienne (2002) vol. 50, no 1 26Edgar, supra note 1, at 298. 27Ibid., at 306-7. See also Adam O. Emmerich, "Hybrid Instruments and the Debt-Equity Distinction in Corporate Taxation" (1985) vol. 52, no. 1 The University of Chicago Law Review 118-48, at 130-33. 28The dividend-received deduction in Canada and the United States and the dividend tax rebate in Australia. 29These percentages are indicative only. I would expect the gap to be a little greater than the estimated highest value to the class of investor most affected by the after-tax cost of one tax treatment over another tax treatment00 little greater than estimated tax value, to make up for errors in estimation. The system should be flexible enough to accommodate improvements in financial value methodology changes and changes to the tax system (such as changes in the company tax rate) that may affect it. 30It is interesting that the American-authored academic literature on the topic of the tax treatment of debt and equity usually does not mention shareholder tax relief, even to the extent of dismissing it as a possibility. See, most recently, Katherine Pratt, "The Debt-Equity Distinction in a Second-Best World" (2000) vol. 53, no. 4 Vanderbilt Law Review 1055-1158. 31One problem with any "once and for all" system is what to do about converting instruments. Take a convertible note that starts out like debt but, some years down the road, converts to an ordinary company share. Under a "once and for all" system, dividends on the share after conversion will remain deductible, creating two classes of ordinary shares: those entitled to debt treatment and those entitled to equity treatment. The result is exact substitutes with different tax treatment.

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