Equity Correlations

Is It Debt Or Is It Equity? The Problem With Hybrid Financial Instruments

Is It Debt Or Is It Equity? The Problem With Using Hybrid Financial Instruments

Leopoldo Parada

Max Planck Institute for Tax Law and Public Finance; University of Valencia

April 28, 2014

Tax Notes International, Vol. 74, No. 4, 2014


The paper discusses the debt/equity classification issues of using hybrid financial instruments under U.S. tax law and when tax treaties come into play.

Is It Debt Or Is It Equity? The Problem With Using Hybrid Financial Instruments – Introduction

This article analyzes the problems derived from the qualification of hybrid financial instruments (HFIs) under the perspective of the U.S. income tax law and the OECD model tax treaty.

HFIs have acquired importance in international business and play an important role in raising capital in a cost-efficient manner, accommodating investor’s demands, hedging risks, and increasing capital flows and investment opportunities that would not have been made otherwise. They also permit the monetization of assets, and because of their flexibility may be used to accommodate the regulation requirements of different countries. This last characteristic intensifies its use mostly in cross-border transactions.

Section I of this article provides a general understanding of HFIs under U.S. income tax law, including an analysis of section 385. Also included are brief comments regarding Notice 94-47, which was issued as a warning to taxpayers that used instruments designed to secure equity treatment for regulatory or financial accounting purposes, but debt treatment for U.S. federal income tax purposes. Section I ends with an analysis of Nestle Holding Inc. v. Commissioner, 70 T.C.M. 682 (1995), and Laidlaw Transportation Inc. et al. v. Commissioner, 75 T.C.M. 2598 (1998), exposing the always complicated distinction between debt and equity, and the costs that can be generated.

Section II focuses on the analysis of articles 10 and 11 of the OECD model tax treaty. It also highlights the role of the commentaries and the effects derived from integration between the tax treaty requirements and the tax regime and qualifications of the income arising from HFIs.

Section III discusses how HFIs are commonly used in U.S. cross-border transactions involving hybrid entities. A brief explanation is included of the controlled foreign corporation netting rules (special allocations of interest expenses) under reg. section 1.861-10(e), as well some types of transactions normally used as planning strategies to obtain a U.S. interest deduction and foreign income exemptions.

U.S. Tax Rules

A hybrid instrument can be defined as a financial instrument that has both debt and equity characteristics and is primarily used to provide specific desired characteristics not present in purer forms of debt or equity.

They are part of a broad class of transactions whose treatment by other authorities (for example, foreign jurisdictions, regulatory bodies, or accounting boards) is different from that determined under U.S. tax laws regarding the deductibility, inclusion, timing, or character of payments made thereunder.

This section analyzes section 385 to organize the general rules to distinguish between debt and equity, including brief comments on Notice 94-47, issued as a warning to taxpayers that used instruments designed to secure equity treatment for regulatory or financial accounting purposes but debt treatment for U.S. federal income tax purposes. This section finishes with an analysis of Nestle Holding Inc. and Laidlaw Transportation Inc., exposing the problem of distinguishing between debt and equity.

The Debt-Equity Distinction

Even though it is not always clear whether an instrument qualifies as debt or equity, this distinction is essential for tax purposes because different taxation schemes may be applied.3 Interest can usually be deducted from taxable income, whereas dividends do not reduce taxable income. Another important difference between debt and equity is the timing of the taxation of payments. Most countries accrue interest income or deductions throughout the term of an instrument that leads to an additional income or a reduction of taxable income, and therefore to an increase or decrease in taxes. In other words, taxes can be reduced or must be paid even though no cash flow of the interest payments took place.

Equity is typically seen as a participation in the entrepreneurial risks and profits of a business. Contributors of capital undertake the risk because of the potential return in the form of profits and enhanced value on their underlying investment. On the other hand, debt is typically seen as an unqualified obligation to pay a sum at a fixed maturity date along with a fixed percentage of interest. As a result, although creditors are preferred in the sense that they are entitled to payment before the common shareholders, they are limited in that their rate of return is generally fixed. The creditor does not take entrepreneurial risk, has no managerial rights, and can enforce the payments of interest and principal.

Equity Correlations debt / equity classification issue

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