Qualification of hybrid financial
instruments in tax treaties
Francisco Alfredo GARCÍA PRATS
Catedrático de Derecho Financiero y Tributario
Jean Monnet Chair on EU Tax Law
Universitat de València (Espanha)
Summary
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Introduction
Concept and typology
Key issues
Remarks on tax treaty qualification
OECD guidelines on HFI income qualification
Dividend/interest qualification
– Dividend income
– Interest income
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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.
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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Typology: some examples
• Debt type shares
– Preference shares
• Equity type loans
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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
F. Alfredo García
IBDT. August 2011
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Key issues
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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
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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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)
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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HFI income as dividend income
• Exhaustive definition not possible
• Relevant tax treaty criteria
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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
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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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:
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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
F. Alfredo García
IBDT. August 2011
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Reaction in the residence State
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Double taxation
Double non taxation
Tax arbitrage
Tax abuse
Counteracting measures
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Against double taxation
Against double non-taxation
Against tax arbitrage
Against tax abuse
F. Alfredo García
IBDT. August 2011
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Double taxation
• Non-deductibility at source state (payor State)
• Taxable income in the residence state of the
investor (no exemption/no credit)
Taxed
income
No
alleviation
double
taxation
source
resident
Non
deductible
dividend
(requalif.,
antiabuse,…)
• Generation of FTC in the residence State: Final
Regulations Reg 156779-06 US, July 18, 2011
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IBDT. August 2011
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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
Dividend
exempt
income
F. Alfredo García
source
resident
IBDT. August 2011
Interest
deductible
income
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Qualification of other State HFI source
• Residence State:
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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 32.232.6)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
F. Alfredo García
IBDT. August 2011
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Counteracting measures
• Switch over clauses
• Avoid duplicate benefits: elimination of
double dipping
• Reaction against abuse: find the proper
reconstruction
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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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).
F. Alfredo García
IBDT. August 2011
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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
F. Alfredo García
IBDT. August 2011
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