Hybrid Financing Instruments
ÜFinancing Instruments that are characterized differently in different jurisdictions ÜExamples –Instruments viewed as “Debt” in one jurisdiction and equity in another (potential double non-taxation) –Instrument issued in by entities disregarded in one jurisdiction –Instruments viewed by different jurisdictions as being owned by different persons
Typical Hybrid instrumentsÜA German AG (the AG) forms a controlled subsidiary in the United States as a US Delaware limited liability company. (the subsidiary) ÜThe subsidiary sells to unrelated investors preferred shares with an aggregate offering price of $800 million. The preferred shares rank prior to the common shares and grant a liquidation preference of $1000 per share (face amount). Distributions e.g. will be paid semi annually from the date of issuance on a noncumulative basis at 10 % per annum until December 31 2019 and thereafter at 10% + 200 bp per annum. The maturity of the preferred shares will be perpetual. The preferred shares are not redeemable prior to January 1 2020. Thereafter, the preferred shares may optionally be redeemed for cash by the subsidiary, in whole or part at a redemption price of $1000 per share plus declared and unpaid dividends to the date of redemption. ÜThe proceeds of the preferred shares and the common shares issuance will be used to fund the acquisition of a newly originated fixed rate subordinated interest deferrable debenture (the spring bond) issued by AG. The spring bond is a fixed rate 10% interest instrument with a five year interest deferral option and a semi annual interest payment frequency. The spring bond will spring away in total, should the parent report a loss in a fiscal year or if the parent should be deemed to be insolvent and will spring back with deferred and accrued interest upon the reversal of any of the aforementioned conditions. The spring bond may be called in whole or in part after December 31, 2019Advantages of Hybrid InstrumentsÜCountries Involved USA & Germany ÜUnder German GAAP & tax purposes Consolidation of US subsidiary and Group taxation applies Spring Bonds are classified as Debt Instrument & fixed interest debt instrument do not attract withholding taxes Preferred shares issued by a German subsidiary SPV are classified as “Equity” under minority interest ÜInterest paid or deferred is tax deductable for federal income tax purpose in Germany (as against “payment basis” in most countries) ÜDividend Income on common shares received by the
German parent is tax exempt under US – Germany DTAAHybrid Instruments in the light of articles 10 and 11 of the OECD Model ConventionArticle 10(3) of OECD model defines the term “Dividend” as two categories of income income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other rights, not being debt-claims, participating in profits; ... [and] income from –other corporate rights; –which is subjected to the same taxation treatment –as income from shares; –by the laws of the State of which the company making the distribution is a resident.Article 11ÜArticle 11(3) of OECD model defines the term “Interest” as The term “interest” as used in this Article means –income from debt-claims of every kind, –whether or not secured by mortgage and –whether or not carrying a right to participate in the debtor’s profits, – and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures; –Penalty charges for late payment shall not be regarded as interest for the purpose of this ArticleÜCorporate Rights Benefit from possible increase in the value of company’s assets; or risk of loss of investment A profit participation right alone is not enough to treat as equity; it must be coupled with participation in the liquidation proceeds (or hidden reserves) of the Company Characteristics like conversion rights, fixed repayment date, fixed interest rate makes a Hybrid instrument difficult to qualify as “Corporate rights”ÜCorporate Rights Variation or absence of control rights do not change the nature of the instrument from “Equity” to “Debt” –No increase or decrease in risk component Examples –Lock-in of shares for fixed term –Stripping of voting rights beyond a threshold limit –Forced voting pattern to be followed –Voluntary voting rights foregoneDetermination Issues?
• No uniform set of objective standards exists • Facts and circumstances • Substance over form • Payer should be able to demonstrate the ability to borrow a similar amount from third party lenders under similar terms • Payer should be able to demonstrate it will be able to meet repayment schedule •Form of the instrument and other indicia of the intent of the parties, • Presence or absence of a fixed maturity date, • Provisions for enforcing payment (i.e., rights upon default, provision for security), • Adequacy of interest and certainty of interest payment, • Degree of subordination to other creditors of the issuer, • Rights to participate in management afforded by the instrument, • Thin or inadequate capitalization, • Source of repayment (income of issuer v liquidation of assets), • Independent creditor test, • Use of funds advanced (whether the funds are used to buy “core assets”), and • Payment mode allowed by the instrument: whether the issuer must repay the cash (or other marketable securities), or can repay the obligation with its own sharesÜPara 19 of OECD MC on Article 11 “Interest as used in Article 11 does not include items of income which are dealt with Article 10 –Example wIf an income from a financial instrument that imparts enough participation in the entrepreneurial risk and thus qualifies as “Corporate Rights” constitute a “Dividend”, even if the income of the financial instrument qualifies the definition of “Interest” under Article 11(3) Income from Corporate Rights and Income from Debt Claims are mutually exclusiveÜThere may be conflicting views of “Determination of Corporate Rights” between contracting states ÜMay lead to situations of one applying Article 10 and other applying Article 11 Say, India applying Article 10 and Singapore applying Article 11 – Double (treble?) taxation Say, India applying Article 11 and Singapore applying Article 10 – Double non-taxation (sans “anti-avoidance”)ÜSeveral MAP gets initiated towards classification of Article 10 and Article 11 ÜOne better way to avoid the problem is to extend the reference of domestic law to the whole of Article 10(3), thereby make domestic law as the final doctrine and avoid MAP? ÜDue to this, treaty negotiations inscribe extra inclusions in Article 10ÜSeveral MAP gets initiated towards classification of Article 10 and Article 11 ÜOne better way to avoid the problem is to extend the reference of domestic law to the whole of Article 10(3), thereby make domestic law as the final doctrine and avoid MAP? ÜDue to this, treaty negotiations inscribe extra inclusions in Article 10ÜGermany-Austria Treaty – Article 10 The term “dividends” as used in this Article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other income which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. The term“ dividends” includes also income derived by a silent partner (“stiller Gesellschafter”) from the partner’s participation as such, income from participating profit sharing loans (“partiarisches Darlehen”) or profit sharing bonds (“Gewinnobligationen”) and similar remuneration provided it is not deductible in determining the taxable income of the borrower under the laws of the Contracting State in which it arises, as well as distributions on share certificates in an investment trustÜEU Directives Parent-Subsidiary Directive –In general applies to profit distributions to a parent company in one member state by its associated subsidiary in another member state, to eliminate double taxation –A possible solution for double-taxation for the Source State, but does not guarantee that both states will apply the same logicÜEU Directives Interest-Royalty Directive –Has wide definition of “Interest”, but disowns Directive application in 4 specific cases, as referred in Article 4(a) to 4(d) of the Directive (put in to avoid double non-taxation) Thin-capitalization Rules –Generally, defines “debt” in a comprehensive manner, but may not define “equity” in detailÜIRS Notice 94-47 covers Hybrid Instruments Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future Whether holders of the Instrument possesses the right to enforce the payment of the principal and interest Whether the rights of holders of the instrument are subordinate to rights of general creditors Whether the instrument give the holders the right to participate in the management of the issuer Whether the issues is thinly capitalized Whether there is identity between holders of the instruments and stockholders of the issuer The label placed upon the instrument by the Parties Whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory agencies, or financial accounting purposes ÜFAS 150 dealing with Hybrid instruments ÜOne example – Perpetual subordinated debt is characterized as “Equity” in US as per above notice and FAS, but the same is characterized as “Debt” under Japanese GAAP and tax regulations
ÜEuro – Pacific rim companies ÜEuro Parent – US Subsidiary company ÜCanadian Hybrid Structure ÜLuxembourg with US Branch•Redeemable Preference Shares •Debt for Pac Rim •Equity for Euro •Dividend paid by Pac Rim Co •Deductible in Pac Rim country •Participation or Foreign tax credit in Europe •Interest withholding tax •0% if paid to UK Financial Inst. •10% in other cases •Thin Capitalization •Euro Issues: Foreign Tax Credit utilization?1.U.S. Hold Co holds US Op Co common and preferred 2.U.S. Hold Co sells Op Co preferred to foreign SPV 3.Euro parent holds put over foreign SPV stock 4.U.S. hold Co holds call over foreign SPV stockÜU.S. treats the put and call as a creating an interest bearing debt instrument Dividends treated as deductible interest Ü ÜForeign jurisdiction treats foreign SPV as eligible for participation exemption Dividends not taxedDescription of the transaction
1.US parent corporation (“US parent”) wholly owns a Canadian operation company (“CanCo”) that carries on business in Canada 2.US parent forms a new Nova Scotia unlimited liability company (“NSULC”) and elects to treat it as a disregarded entity for U.S. tax purposes 3.US parent transfers its shares of CanCo to NSULC in exchange for stock and debt (the “Note”) 4.NSULC exchanges its CanCo stock for new CanCo stock and a note with interest payable solely in shares of CanCo and principal payable in cash 5.CanCo enters into a forward purchase agreement (“FPA”) with USP whereby CanCo agrees to sell and USP agrees to buy shares of CanCo equal to the principal amount of the Note. The price the shares is set on the date the FPA is entered into
LuxCo with US Finance Branch
Intended US tax treatment
1.Deduction for interest on U.S. loans, subject to applicable limitations 2.No U.S. tax imposed on US LP/GP if no trade or business in the U.S Withholding tax exemption under US-Luxembourg Treaty 3.If US LP/GP conducts U.S. trade or business, there would be taxable basis in U.S., but reduced by interest paid by Lux SNC to LuxCo 4.Considerations: 1.Level of activity needed to satisfy Luxembourg P/E requirements 2.Effect of inconsistent Treaty positions in the U.S. and Luxembourg 3.U.S thin capitalization considerations 4.Potential branch profits tax 5.Intended Euro Tax Treatment 1.Participation exemption for distributions for LuxCo 2.Foreign controlled foreign corporation rules not applicable to LuxCo, Lux SNC or US LP/GPLuxCo with US Finance Branch
Intended Luxembourg tax treatment
1.Binding ruling should be obtained from Lux authorities that US LP/GP constitutes a P/E for Lux tax purposes 2.Interest payments from U.S. not subject to Luxembourg tax because they are received by a U.S. P/E 3.Only small tax base in Luxembourg 4.No withholding tax on distributions to Foreign parent 5. Considerations: 1.Luxembourg capital tax (possible use of merger structure) 2.Established sufficient U.S. activity/presence for LuxP/E without creating a U.S P/E under U.S. tax rules 3.US LP/GP must be transparent from a Luxembourg point of view 4.Lux functional currency advance tax agreement availableWhat is “Equity Function?”
ÜIt is a transfer pricing concept, wherein, intra-group interest is disallowed, equating the loan given as equity, and proving that loan, in fact, has functioned as equity, due to thin capitalization of the debtor ÜRing fencing clause, for over usage of Hybrid Instruments ÜMostly happens for outward investments, where the loan given is treated as “equity given” due to circumstances and terms of the loan (economic substances is looked into, more than tax substance)
Typical Hybrid instrumentsÜA German AG (the AG) forms a controlled subsidiary in the United States as a US Delaware limited liability company. (the subsidiary) ÜThe subsidiary sells to unrelated investors preferred shares with an aggregate offering price of $800 million. The preferred shares rank prior to the common shares and grant a liquidation preference of $1000 per share (face amount). Distributions e.g. will be paid semi annually from the date of issuance on a noncumulative basis at 10 % per annum until December 31 2019 and thereafter at 10% + 200 bp per annum. The maturity of the preferred shares will be perpetual. The preferred shares are not redeemable prior to January 1 2020. Thereafter, the preferred shares may optionally be redeemed for cash by the subsidiary, in whole or part at a redemption price of $1000 per share plus declared and unpaid dividends to the date of redemption. ÜThe proceeds of the preferred shares and the common shares issuance will be used to fund the acquisition of a newly originated fixed rate subordinated interest deferrable debenture (the spring bond) issued by AG. The spring bond is a fixed rate 10% interest instrument with a five year interest deferral option and a semi annual interest payment frequency. The spring bond will spring away in total, should the parent report a loss in a fiscal year or if the parent should be deemed to be insolvent and will spring back with deferred and accrued interest upon the reversal of any of the aforementioned conditions. The spring bond may be called in whole or in part after December 31, 2019Advantages of Hybrid InstrumentsÜCountries Involved USA & Germany ÜUnder German GAAP & tax purposes Consolidation of US subsidiary and Group taxation applies Spring Bonds are classified as Debt Instrument & fixed interest debt instrument do not attract withholding taxes Preferred shares issued by a German subsidiary SPV are classified as “Equity” under minority interest ÜInterest paid or deferred is tax deductable for federal income tax purpose in Germany (as against “payment basis” in most countries) ÜDividend Income on common shares received by the
German parent is tax exempt under US – Germany DTAAHybrid Instruments in the light of articles 10 and 11 of the OECD Model ConventionArticle 10(3) of OECD model defines the term “Dividend” as two categories of income income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other rights, not being debt-claims, participating in profits; ... [and] income from –other corporate rights; –which is subjected to the same taxation treatment –as income from shares; –by the laws of the State of which the company making the distribution is a resident.Article 11ÜArticle 11(3) of OECD model defines the term “Interest” as The term “interest” as used in this Article means –income from debt-claims of every kind, –whether or not secured by mortgage and –whether or not carrying a right to participate in the debtor’s profits, – and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures; –Penalty charges for late payment shall not be regarded as interest for the purpose of this ArticleÜCorporate Rights Benefit from possible increase in the value of company’s assets; or risk of loss of investment A profit participation right alone is not enough to treat as equity; it must be coupled with participation in the liquidation proceeds (or hidden reserves) of the Company Characteristics like conversion rights, fixed repayment date, fixed interest rate makes a Hybrid instrument difficult to qualify as “Corporate rights”ÜCorporate Rights Variation or absence of control rights do not change the nature of the instrument from “Equity” to “Debt” –No increase or decrease in risk component Examples –Lock-in of shares for fixed term –Stripping of voting rights beyond a threshold limit –Forced voting pattern to be followed –Voluntary voting rights foregoneDetermination Issues?
• No uniform set of objective standards exists • Facts and circumstances • Substance over form • Payer should be able to demonstrate the ability to borrow a similar amount from third party lenders under similar terms • Payer should be able to demonstrate it will be able to meet repayment schedule •Form of the instrument and other indicia of the intent of the parties, • Presence or absence of a fixed maturity date, • Provisions for enforcing payment (i.e., rights upon default, provision for security), • Adequacy of interest and certainty of interest payment, • Degree of subordination to other creditors of the issuer, • Rights to participate in management afforded by the instrument, • Thin or inadequate capitalization, • Source of repayment (income of issuer v liquidation of assets), • Independent creditor test, • Use of funds advanced (whether the funds are used to buy “core assets”), and • Payment mode allowed by the instrument: whether the issuer must repay the cash (or other marketable securities), or can repay the obligation with its own sharesÜPara 19 of OECD MC on Article 11 “Interest as used in Article 11 does not include items of income which are dealt with Article 10 –Example wIf an income from a financial instrument that imparts enough participation in the entrepreneurial risk and thus qualifies as “Corporate Rights” constitute a “Dividend”, even if the income of the financial instrument qualifies the definition of “Interest” under Article 11(3) Income from Corporate Rights and Income from Debt Claims are mutually exclusiveÜThere may be conflicting views of “Determination of Corporate Rights” between contracting states ÜMay lead to situations of one applying Article 10 and other applying Article 11 Say, India applying Article 10 and Singapore applying Article 11 – Double (treble?) taxation Say, India applying Article 11 and Singapore applying Article 10 – Double non-taxation (sans “anti-avoidance”)ÜSeveral MAP gets initiated towards classification of Article 10 and Article 11 ÜOne better way to avoid the problem is to extend the reference of domestic law to the whole of Article 10(3), thereby make domestic law as the final doctrine and avoid MAP? ÜDue to this, treaty negotiations inscribe extra inclusions in Article 10ÜSeveral MAP gets initiated towards classification of Article 10 and Article 11 ÜOne better way to avoid the problem is to extend the reference of domestic law to the whole of Article 10(3), thereby make domestic law as the final doctrine and avoid MAP? ÜDue to this, treaty negotiations inscribe extra inclusions in Article 10ÜGermany-Austria Treaty – Article 10 The term “dividends” as used in this Article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other income which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. The term“ dividends” includes also income derived by a silent partner (“stiller Gesellschafter”) from the partner’s participation as such, income from participating profit sharing loans (“partiarisches Darlehen”) or profit sharing bonds (“Gewinnobligationen”) and similar remuneration provided it is not deductible in determining the taxable income of the borrower under the laws of the Contracting State in which it arises, as well as distributions on share certificates in an investment trustÜEU Directives Parent-Subsidiary Directive –In general applies to profit distributions to a parent company in one member state by its associated subsidiary in another member state, to eliminate double taxation –A possible solution for double-taxation for the Source State, but does not guarantee that both states will apply the same logicÜEU Directives Interest-Royalty Directive –Has wide definition of “Interest”, but disowns Directive application in 4 specific cases, as referred in Article 4(a) to 4(d) of the Directive (put in to avoid double non-taxation) Thin-capitalization Rules –Generally, defines “debt” in a comprehensive manner, but may not define “equity” in detailÜIRS Notice 94-47 covers Hybrid Instruments Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future Whether holders of the Instrument possesses the right to enforce the payment of the principal and interest Whether the rights of holders of the instrument are subordinate to rights of general creditors Whether the instrument give the holders the right to participate in the management of the issuer Whether the issues is thinly capitalized Whether there is identity between holders of the instruments and stockholders of the issuer The label placed upon the instrument by the Parties Whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory agencies, or financial accounting purposes ÜFAS 150 dealing with Hybrid instruments ÜOne example – Perpetual subordinated debt is characterized as “Equity” in US as per above notice and FAS, but the same is characterized as “Debt” under Japanese GAAP and tax regulations
ÜEuro – Pacific rim companies ÜEuro Parent – US Subsidiary company ÜCanadian Hybrid Structure ÜLuxembourg with US Branch•Redeemable Preference Shares •Debt for Pac Rim •Equity for Euro •Dividend paid by Pac Rim Co •Deductible in Pac Rim country •Participation or Foreign tax credit in Europe •Interest withholding tax •0% if paid to UK Financial Inst. •10% in other cases •Thin Capitalization •Euro Issues: Foreign Tax Credit utilization?1.U.S. Hold Co holds US Op Co common and preferred 2.U.S. Hold Co sells Op Co preferred to foreign SPV 3.Euro parent holds put over foreign SPV stock 4.U.S. hold Co holds call over foreign SPV stockÜU.S. treats the put and call as a creating an interest bearing debt instrument Dividends treated as deductible interest Ü ÜForeign jurisdiction treats foreign SPV as eligible for participation exemption Dividends not taxedDescription of the transaction
1.US parent corporation (“US parent”) wholly owns a Canadian operation company (“CanCo”) that carries on business in Canada 2.US parent forms a new Nova Scotia unlimited liability company (“NSULC”) and elects to treat it as a disregarded entity for U.S. tax purposes 3.US parent transfers its shares of CanCo to NSULC in exchange for stock and debt (the “Note”) 4.NSULC exchanges its CanCo stock for new CanCo stock and a note with interest payable solely in shares of CanCo and principal payable in cash 5.CanCo enters into a forward purchase agreement (“FPA”) with USP whereby CanCo agrees to sell and USP agrees to buy shares of CanCo equal to the principal amount of the Note. The price the shares is set on the date the FPA is entered into
LuxCo with US Finance Branch
Intended US tax treatment
1.Deduction for interest on U.S. loans, subject to applicable limitations 2.No U.S. tax imposed on US LP/GP if no trade or business in the U.S Withholding tax exemption under US-Luxembourg Treaty 3.If US LP/GP conducts U.S. trade or business, there would be taxable basis in U.S., but reduced by interest paid by Lux SNC to LuxCo 4.Considerations: 1.Level of activity needed to satisfy Luxembourg P/E requirements 2.Effect of inconsistent Treaty positions in the U.S. and Luxembourg 3.U.S thin capitalization considerations 4.Potential branch profits tax 5.Intended Euro Tax Treatment 1.Participation exemption for distributions for LuxCo 2.Foreign controlled foreign corporation rules not applicable to LuxCo, Lux SNC or US LP/GPLuxCo with US Finance Branch
Intended Luxembourg tax treatment
1.Binding ruling should be obtained from Lux authorities that US LP/GP constitutes a P/E for Lux tax purposes 2.Interest payments from U.S. not subject to Luxembourg tax because they are received by a U.S. P/E 3.Only small tax base in Luxembourg 4.No withholding tax on distributions to Foreign parent 5. Considerations: 1.Luxembourg capital tax (possible use of merger structure) 2.Established sufficient U.S. activity/presence for LuxP/E without creating a U.S P/E under U.S. tax rules 3.US LP/GP must be transparent from a Luxembourg point of view 4.Lux functional currency advance tax agreement availableWhat is “Equity Function?”
ÜIt is a transfer pricing concept, wherein, intra-group interest is disallowed, equating the loan given as equity, and proving that loan, in fact, has functioned as equity, due to thin capitalization of the debtor ÜRing fencing clause, for over usage of Hybrid Instruments ÜMostly happens for outward investments, where the loan given is treated as “equity given” due to circumstances and terms of the loan (economic substances is looked into, more than tax substance)