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Qualification of hybrid financial instruments in tax treaties Francisco Alfredo GARCÍA PRATS Catedrático de Derecho Financiero y Tributario Jean Monnet.

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Presentation on theme: "Qualification of hybrid financial instruments in tax treaties Francisco Alfredo GARCÍA PRATS Catedrático de Derecho Financiero y Tributario Jean Monnet."— Presentation transcript:


2 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)

3 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 GarcíaIBDT. August 20113

4 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 GarcíaIBDT. August 20114

5 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 GarcíaIBDT. August 20115

6 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 F. Alfredo GarcíaIBDT. August 20116

7 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 F. Alfredo GarcíaIBDT. August 20117

8 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 GarcíaIBDT. August 20118

9 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 GarcíaIBDT. August 20119

10 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 GarcíaIBDT. August 201110

11 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 F. Alfredo GarcíaIBDT. August 201111

12 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 GarcíaIBDT. August 201112

13 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 F. Alfredo GarcíaIBDT. August 201113

14 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 F. Alfredo GarcíaIBDT. August 201114

15 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,…) Taxed income No alleviation double taxation Taxed income No alleviation double taxation F. Alfredo GarcíaIBDT. August 201115

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 resident source Interest deductible income Dividend exempt income F. Alfredo GarcíaIBDT. August 201116

17 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 F. Alfredo GarcíaIBDT. August 201117

18 Counteracting measures Switch over clauses Avoid duplicate benefits: elimination of double dipping Reaction against abuse: find the proper reconstruction F. Alfredo GarcíaIBDT. August 201118

19 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 GarcíaIBDT. August 201119

20 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 GarcíaIBDT. August 201120

21 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 GarcíaIBDT. August 201121

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