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Tax Treaty Qualification of Hybrid Financial Instruments

This paper explores the qualification of hybrid financial instruments in tax treaties, examining key issues such as dividend and interest income, withholding at source, double taxation, tax arbitrage, and counteracting measures. The author delves into OECD guidelines and the implications for source and residence states.

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Tax Treaty Qualification of Hybrid Financial Instruments

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  1. Qualification of hybrid financial instruments in tax treaties Francisco Alfredo GARCÍA PRATS Catedrático de Derecho Financiero y Tributario Jean MonnetChairon EU TaxLaw Universitat de València (Espanha)

  2. Summary • Introduction • Concept and typology • Key issues • Remarksontaxtreatyqualification • OECD guidelineson HFI incomequalification • Dividend/interestqualification • Dividendincome • Interestincome • Withholding/notwithholding at source • Reaction of theResidenceState • BindingqualificationfromSourceState? • Doubletaxation/double non-taxation • TaxArbitrage • Final considerations IBDT. August 2011

  3. Introduction • Growingimportance of thesubject: • Alternativefinancialinvestment • HFI beingblamed as one cause of the crisis • Complexity of thesubject • Diversification, flexibilitytools • Diverse legal frameworksinvolved: regulatory, accounting, commercial, taxregimes • Cross-borderaspects: increasethetaxarbitrage and risksituations. IBDT. August 2011

  4. Concept • Hybridfinancialinstruments: instrumentswhichincorporateelements of bothequity and debt: greatvariety • Non-tax and taxpurposes • Debt-equitytaxtreatmentdistinction: stillvalid? • TaxTreatytreatmentonly a part of thegame • Domestictaxtreatment and taxtreatyintegrationalsokeyissues • Taxarbitrage • Doubletaxation/double non-taxation • Opporunities and/butrisks • Legal basisfordistinctiondebt-equity IBDT. August 2011

  5. Typology: some examples • Debttype shares • Preference shares • Equitytypeloans • Jouissancerights, • Silentpartnerships • Participationbonds • Convertible bonds • Warrant bonds • Profitparticipatingloans • Derivativesfinancing: options, forwards, swaps, , CDS, CDO • Buttheyneedto be reclassifiedintotaxtreatyincomecategories IBDT. August 2011

  6. Key issues • Debt/equitydistinction • HFI : incomeor simple cash-flow • SourceState/no sourceStatetaxation • Doubletaxation/double non-taxation • Abusive use of HFI • Taxarbitrage: licit vs ilicit • Counteractingmeasures: scope, effectiveness and validity IBDT. August 2011

  7. Remarks on tax treaty qualification • Term ‘as used in thisarticle’ vs ‘forthepurposes of thisconvention’: implicationsforinterest and dividendincome • Determination of allocation rule beingapplicable • Someissuesexcluded: allocation of expenses, taxregime, doubletaxationmeasures: ‘international’ assumptions • Role of thedomestictaxqualification • Interaction DTC-domestictax of greaterrelevance IBDT. August 2011

  8. OECD MC guidelinesfortaxtreatyqualification of HFI • Lack of specifictreatment/reference in the MC itself • Classicalqualificationto be followed: dividend/interest/CG/businessincome/otherincome • Specificreference in thecommentaries: • Art 11 Comm 21.1: non traditionalfinancialinstruments (1994 OECD Report) • Art 10 Comm 25: loan as a capital; interest as dividend • Art 11 Comm 19: participatingbonds, convertible bonds • Anti-abuse mechanisms can be usedtocounteract HFI abuse beforethetreaty (HTC 1998, p. 170) IBDT. August 2011

  9. Dividend-interest qualification • Dividendqualificationtakesprecedence • Art 11 Comm 19 • Potentialconflictswiththecorrespondingdefinitions • SourceStatebindingqualification (dividends) vs Closedtaxtreatydefinition (interest) • SometaxtreatyState’spractice • Isitpossibletoidentify a common/coherentdefinitioncriteria? • Definitionalrisk: businessrisk vs debtrisk IBDT. August 2011

  10. HFI income as dividend income • Exhaustivedefinitionnotpossible • Relevanttaxtreatycriteria • Incomefrom ‘corporaterights’ • Risktaking: entrepreneurialrisk • Otherrelevantelements • Holding position as a criterion: usufruct • Domesticclassification and treatment (relevance): sametaxationtreatment at sourceState • Interestincome as dividendincomefor DTC purposes IBDT. August 2011

  11. HFI income as interest income • Closedtaxtreatydefinition: no referencetosourcestateincomeclassification • ButMemberStatespractice • Debtclaimmustexist • Remunerationformakingcapital available: exchange of a principal mustexist • Negativedelimitation: creditriskmustnotbecomebusinessrisk • Notallderivativeinstrumentsbeingconsideredby OECD MC IBDT. August 2011

  12. Use of HFI toavoidwithholdingtax at source: GC orotherincome • Derivativeinstruments: mayavoidtaxtreatyqualificationinvolvingwithholding • Put-callparitytheorem • Examples: • CDS • CDI • Currency swaps • TROR • Credit-linked notes • Somestatesreaction: • Portugal (interestincome) • US: dividendequivalentincome • Counteracting anti-abusivemeasures: • Balance of counteractingmeasures IBDT. August 2011

  13. Reaction in the residence State • Doubletaxation • Double non taxation • Taxarbitrage • Tax abuse • Counteractingmeasures • Againstdoubletaxation • Againstdouble non-taxation • Againsttaxarbitrage • Againsttax abuse IBDT. August 2011

  14. Double taxation • Non-deductibility at sourcestate (payorState) • Taxableincome in theresidencestate of theinvestor (no exemption/no credit) • Generation of FTC in theresidenceState: Final RegulationsReg 156779-06 US, July 18, 2011 Taxedincome No alleviationdoubletaxation Non deductibledividend (requalif., antiabuse,…) resident source IBDT. August 2011

  15. Double non-taxation • Classification as debt in the source state of the yield of the hybrid financial instrument • Classification as equity in the residence state of the yield of the hybrid financial instrument Dividendexemptincome Interestdeductibleincome resident source IBDT. August 2011

  16. Qualification of otherState HFI source • ResidenceState: • Boundbysourcestatequalification? • Boundbytreatyqualification? • Uniform-separatequalificationpossible? • Boundforwhichpurposes? • Wouldbindingqualificationsolvetheproblems? • ResidenceStateboundtoeliminatedoubletaxationunder DTC (Comm 32.1) givingrelief • NotboundtofollowSourceStatequalification • Conflicts of qualificationderivedfrominterpretationissues (comm 32.2-32.6)of thetreaty • Conflicts of qualificationderivedfromdifferences of domesticlaw: no problemprovidedoubletaxationreliefisgranted • Conflicts of qualificationderivedfromconflicts of fact: MAP • Conflictsresulting in double non-taxation: Residencemaydenyrelief IBDT. August 2011

  17. Counteracting measures • Switch over clauses • Avoid duplicate benefits: elimination of double dipping • Reaction against abuse: find the proper reconstruction IBDT. August 2011

  18. Taxarbitrage/tax abuse and counteractingmeasures • Validity of taxarbitrage: anongoingdiscussion • Rosenbloom/Avi-Yonah positions. • Counteractingmeasurestotackletaxarbitrage and taxtreaties • Different positions in practice: • Art 24.4.c) US-UK taxtreaty (protocol) • UK: Bayfine UK vs Commissionaersfor HMRC [2011] EWCA Civ 304, Court of Appeal 23-3-2011 • NZL: High Court, BNZ LimitedInvestments and Ors v. Comm’r of InlandRevenue, Civ 2004-485-1059, p. 265. 15-7-2009 IBDT. August 2011

  19. Domesticcounteractingmeasuresagainsttaxarbitrage • (1) Limiting the scope of the participation exemption regime if the payments on hybrid financial instruments (HFIs) are deductible at the level of the issuing company; • (2) Restricting interest deductibility at the level of the issuing company if the instrument is treated as equity in the state of residence of the investor. • Examples: • UK. Finance (No. 2) Act 2005, Secs. 24 to 31 and Schedule 3. • HRMC. Guidance, FA 96/S91A-G, under the heading “Taxing Loan Relationships: Anti-Avoidance: Shares as Debt” • HMRC, “Avoidance Involving Tax Arbitrage”, Guidance Notes. • Germany. 2007 German Annual Tax Act. Narrowing the scope of participation exemption • Denmark: Act No. 98 of 10 February 2009 (Based on Bill L 23). IBDT. August 2011

  20. Final considerations • Up tonow: don’texpecttoomuchfromtaxtreatiestosolverisks and uncertaintiesrelatedtocross-border HFI income • OECD tofurtherdevelopinternationalstandardsonthematter • Greatercoordination of unilateral taxation and counteractingmeasuresneeded. • Ifriskidentificationkeytodistinguishequity/debtincome: needtoimproveriskidentification and riskmeasurementtechniques IBDT. August 2011

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