| Using variants of a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when there is some scope to evade taxes on foreign capital income, when interest income and capital gains/losses are taxed differentially for some agents, and when foreign currency exposure can be hedged using forward contracts and a set of currency options.;Studying the implications for portfolio choices and pricing relationships in international capital markets using an extension of the Martingale methodology for the characterization of asset prices, we obtain tax-modified uncovered interest parity conditions, Fisher conditions and forward prices similar to the ones derived for the no-tax case, but augmented by "risk-premium" terms, featuring the conditional Martingale covariances of exchange rates/price indices and tax factors, normalized by the conditional Martingale expectations of the latter. Tax-modified option prices can be similarly decomposed, with the "risk-premium" terms in this case featuring the conditional Martingale covariance of exercise values and tax factors, normalized by the conditional Martingale expectation of the latter. Tax-modified versions of the put-call parity conditions are derived that revert to their standard (no-tax) format if the respective marginal agents in the bond and option markets are in identical tax brackets. Covered interest parity and Fisher conditions remain unaffected by the introduction of capital income taxes, consequences of our approach of bounding tax-based arbitrage without restricting arbitrage per se. Our results match the stylized facts regarding these pricing relationships.;The methodology developed and used throughout can be adapted to analyze a wide range of situations where tax arbitrage opportunities due to tax wedges prevailing in an international environment may seem exploitable for international portfolio investors. |
