Using Hybrid Instruments to Reduce Cost of Capital in Cross-border Transactions
Different countries have different ways of treating debt and equity for tax purposes.
Hybrid instruments are a play on the difference in tax laws of differing jurisdictions, typically resulting in interest deductions in one country but corresponding tax-exempt dividends in another country.
For example, if a Canadian parent with a U.S. subsidiary receives dividends from the subsidiary by using a hybrid instrument, the dividends may be treated as interest for U.S. tax purposes. The interest payments to the Canadian parent would generally be deductible for the U.S. subsidiary, subject to certain restrictions.
However, for Canadian tax purposes the dividends may be deductible under Canada’s exempt surplus rules.
Depending on a variety of factors, the tax savings may be in the range of $150,000 to $400,000 per year for every $10,000,000 of capital invested in a subsidiary (1.5% to 4.0%). Hybrid instruments can significantly reduce a corporate group’s cost of capital for businesses with international or cross-border operations.
The Organization for Economic Cooperation and Development (OECD) has become concerned with the so-called “double non-taxation” resulting from hybrid instruments. The OECD discusses the issue in the Base Erosion and Profit Shifting Report (BEPS), and recommends that countries enact domestic anti-hybrid legislation. One of the suggested rules would deny interest deductibility in the source country (e.g., the U.S. in the above example) on a hybrid instrument.
The BEPS report acknowledges it is not always clear which country suffers loss of tax revenue. In our view, the question of whether there is a tax loss depends on whether the base case for comparison is debt or equity financing for the foreign subsidiary. Some countries have already enacted anti-hybrid rules, but it remains to be seen whether other countries will follow the OECD recommendations.
Despite the BEPS report, the Canadian tax authorities not been adverse to the use of hybrid instruments so far.
For example, the Canada Revenue Agency permitted the use of a Luxembourg hybrid instrument in at least one advance tax ruling, as summarized in this article.
Subject to changes in tax law, hybrid instruments may benefit not only Canadian companies doing business abroad, but also non-Canadian companies that structure through jurisdictions such as Canada and Luxembourg. Canada’s existing tax and economic policy in this area may be quite sound, given the resulting incentives for companies to repatriate profits to reinvest in the Canadian economy. It also encourages foreign direct investment into Canada.
Invitation for Discussion:
Shea Nerland LLP is a member of Geneva Group International (GGI), a global network of law firms and accounting firms. If you would like to discuss hybrid instruments or any other tax matter, please contact one of the lawyers in the Tax & Estate Planning group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.