Qualification of hybrid financial instruments in tax treaties

2. 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)

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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

17. 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

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

19. 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

20. 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

21. 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