The optimal timing of the transfer of hidden reserves in the German and Austrian tax systems

The lower‐of‐cost‐or‐market principle implies that assets may be sold above book value, by which hidden reserves are disclosed. To avoid taxation of these hidden reserves, in German‐speaking countries companies are allowed to transfer them to a newly purchased asset within a fixed time period. In this paper, the optimal timing of hidden reserves transfers is developed with special attention to the term structure of interest rates and interest rate risk, and using the replicating principle known from the field of finance. The paper presents one model under certainty and, as a generalization of this model, another model under interest rate risk. In both models, the criterion used for decision‐making is the value of the right to transfer, which can be interpreted as the initial cost of a replicating/hedging strategy for tax payments saved/incurred. In the model under certainty, the net present value concept is used to derive the value of the right to transfer. The procedure used in the model under interest rate risk is a combination of flexible planning and the no‐arbitrage approach common in derivatives pricing. It is shown that the right to transfer hidden reserves with flexible timing is equivalent to an American‐style exchange option. In addition, the impact of term‐structure volatility on the value of the right to transfer is analyzed. The technique presented in this paper can also be used to solve other timing problems resulting from trade‐offs between early and late tax payments/tax benefits. Copyright © 2002 John Wiley & Sons, Ltd.