Qualification of hybrid financial instruments in tax treaties

Qualification of hybrid financial instruments in tax treaties

Francisco Alfredo GARCÍA PRATSCatedrático de Derecho Financiero y Tributario

Jean Monnet Chair on EU Tax LawUniversitat de València (Espanha)

Summary• Introduction• Concept and typology• Key issues• Remarks on tax treaty qualification• OECD guidelines on HFI income qualification• Dividend/interest qualification

– Dividend income– Interest income

• Withholding/not withholding at source• Reaction of the Residence State• Binding qualification from Source State?• Double taxation/double non-taxation• Tax Arbitrage• Final considerations

F. Alfredo García IBDT. August 2011 3

Introduction

• Growing importance of the subject: – Alternative financial investment– HFI being blamed as one cause of the crisis

• Complexity of the subject– Diversification, flexibility tools– Diverse legal frameworks involved: regulatory,

accounting, commercial, tax regimes– Cross-border aspects: increase the tax arbitrage

and risk situations.


Concept • Hybrid financial instruments: instruments which

incorporate elements of both equity and debt: great variety– Non-tax and tax purposes

• Debt-equity tax treatment distinction: still valid?– Tax Treaty treatment only a part of the game– Domestic tax treatment and tax treaty integration also key

issues• Tax arbitrage• Double taxation/double non-taxation• Opporunities and/but risks

• Legal basis for distinction debt-equity


Typology: some examples• Debt type shares

– Preference shares• Equity type loans

– Jouissance rights, – Silent partnerships– Participation bonds– Convertible bonds– Warrant bonds– Profit participating loans

• Derivatives financing: options, forwards, swaps, , CDS, CDO• But they need to be reclassified into tax treaty income

categories


Key issues

• Debt/equity distinction• HFI : income or simple cash-flow• Source State/no source State taxation• Double taxation/double non-taxation• Abusive use of HFI• Tax arbitrage: licit vs ilicit• Counteracting measures: scope, effectiveness

and validity


Remarks on tax treaty qualification• Term ‘as used in this article’ vs ‘for the purposes

of this convention’: implications for interest and dividend income

• Determination of allocation rule being applicable• Some issues excluded: allocation of expenses, tax

regime, double taxation measures: ‘international’ assumptions

• Role of the domestic tax qualification• Interaction DTC-domestic tax of greater

relevance


OECD MC guidelines for tax treaty qualification of HFI

• Lack of specific treatment/reference in the MC itself• Classical qualification to be followed:

dividend/interest/CG/business income/other income• Specific reference in the commentaries:

– Art 11 Comm 21.1: non traditional financial instruments (1994 OECD Report)

– Art 10 Comm 25: loan as a capital; interest as dividend– Art 11 Comm 19: participating bonds, convertible bonds

• Anti-abuse mechanisms can be used to counteract HFI abuse before the treaty (HTC 1998, p. 170)


Dividend-interest qualification

• Dividend qualification takes precedence– Art 11 Comm 19

• Potential conflicts with the corresponding definitions– Source State binding qualification (dividends) vs

Closed tax treaty definition (interest)• Some tax treaty State’s practice• Is it possible to identify a common/coherent

definition criteria? – Definitional risk: business risk vs debt risk


HFI income as dividend income• Exhaustive definition not possible• Relevant tax treaty criteria

– Income from ‘corporate rights’– Risk taking: entrepreneurial risk– Other relevant elements– Holding position as a criterion: usufruct

• Domestic classification and treatment (relevance): same taxation treatment at source State

• Interest income as dividend income for DTC purposes


HFI income as interest income• Closed tax treaty definition: no reference to

source state income classification– But Member States practice

• Debt claim must exist• Remuneration for making capital available:

exchange of a principal must exist• Negative delimitation: credit risk must not

become business risk• Not all derivative instruments being considered

by OECD MC


Use of HFI to avoid withholding tax at source: GC or other income

• Derivative instruments: may avoid tax treaty qualification involving withholding– Put-call parity theorem

• Examples:– CDS– CDI– Currency swaps– TROR– Credit-linked notes

• Some states reaction:– Portugal (interest income)– US: dividend equivalent income

• Counteracting anti-abusive measures:– Balance of counteracting measures


Reaction in the residence State

• Double taxation• Double non taxation• Tax arbitrage• Tax abuse• Counteracting measures

– Against double taxation– Against double non-taxation– Against tax arbitrage– Against tax abuse


Double taxation• Non-deductibility at source state (payor State)• Taxable income in the residence state of the

investor (no exemption/no credit)

• Generation of FTC in the residence State: Final Regulations Reg 156779-06 US, July 18, 2011

resident source

Non deductible dividend (requalif.,

antiabuse,…)

Non deductible dividend (requalif.,

antiabuse,…)

Taxed income

No alleviation

double taxation

Taxed income

No alleviation

double taxation


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

resident source

Interest deductible

income

Interest deductible

income

Dividend exempt income

Dividend exempt income


Qualification of other State HFI source• Residence State:

– Bound by source state qualification? – Bound by treaty qualification? – Uniform-separate qualification possible? – Bound for which purposes?– Would binding qualification solve the problems?

• Residence State bound to eliminate double taxation under DTC (Comm 32.1) giving relief

• Not bound to follow Source State qualification– Conflicts of qualification derived from interpretation issues (comm 32.2-

32.6)of the treaty– Conflicts of qualification derived from differences of domestic law: no

problem provide double taxation relief is granted– Conflicts of qualification derived from conflicts of fact: MAP– Conflicts resulting in double non-taxation: Residence may deny relief


Counteracting measures

• Switch over clauses• Avoid duplicate benefits: elimination of

double dipping• Reaction against abuse: find the proper

reconstruction


Tax arbitrage/tax abuse and counteracting measures

• Validity of tax arbitrage: an ongoing discussion– Rosenbloom/Avi-Yonah positions.

• Counteracting measures to tackle tax arbitrage and tax treaties– Different positions in practice:– Art 24.4.c) US-UK tax treaty (protocol)– UK: Bayfine UK vs Commissionaers for HMRC [2011]

EWCA Civ 304, Court of Appeal 23-3-2011– NZL: High Court, BNZ Limited Investments and Ors v.

Comm’r of Inland Revenue, Civ 2004-485-1059, p. 265. 15-7-2009


Domestic counteracting measures against tax arbitrage

• (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).


Final considerations

• Up to now: don’t expect too much from tax treaties to solve risks and uncertainties related to cross-border HFI income

• OECD to further develop international standards on the matter

• Greater coordination of unilateral taxation and counteracting measures needed.

• If risk identification key to distinguish equity/debt income: need to improve risk identification and risk measurement techniques


Documents

Qualification of hybrid financial instruments in tax treaties