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Hybrid financial instruments

A hybrid financial instrument is an instrument that is classified as debt in the country in which the issuer was formed and as equity in other country. In other words, it is a financial instruments that blend characteristics of debt and equity markets. Convertible bonds are an example. They are debt instruments that have an imbedded option allowing the holder to exchange them for shares of the issuing corporation’s stock. For this reason, their market prices tend to be influenced by both interest rates as well as the issuer’s stock price. Another example would be a structured note linked to some equity index. These take many forms. Typical would be a five year note. It is a debt instrument issued by a corporation or sovereign, but instead of paying interest, it returns the greater of principal plus the price appreciation on the S&P 500 over the life of the instrument, or principal. Other examples of hybrids are preferred stock, trust preferred securities (TruPS) or equity default swaps (EDS).

Hybrid financial instruments are being increasingly used in cross border transactions, including structuring cross-border acquisitions and dispositions, tax-free spin-offs, recapitalizations, and reorganizations.

One of the strategic reasons for designing an issuance that uses a hybrid instrument is tax savings, which is often a primary motivation. Typically, the issuer is seeking a deduction for the interest, which could only be available if the instrument qualified as debt. In the other country, however, the holder is seeking to avoid the recognition of income in advance of the receipt of cash. The general rule is that investments in stock in a foreign corporation are not taxed until the corporation pays a dividend or the shareholder sells the stock, so long as the foreign company is not a CFC (Controlled Foreign Corporation) or PFIC (Passive Foreign Investment Company). However, interest on debt instruments must be included in income by holders of the debt instruments as it accrues, even if the interest is not required to be paid until maturity.

Hybrid investments also can be useful in avoiding capital duties—taxes based on the equity capital contributed to a company that do not apply to debt capital.

However, there may be reasons separate from tax savings. For example, Fidelitas worked on a deal where we used hybrid instruments to channel investments into a media company in another country. The regulations in that country prohibited foreign investors from acquiring significant ownership in media companies. In this case, the hybrid instrument—convertible notes and subordinated equity notes issued by an affiliate of the media company—allowed the media company to receive a cash infusion from a foreign company without running afoul of local regulations. In the local country, the notes were treated as issuance of debt. In the other country, the notes were treated as equity. Accordingly, the yield on the instruments were not required to be included in income prior to payment.

Another non-tax reason for investors to use hybrids may be where management has invested in a company that proposes to issue pure equity shares. Investors often oppose such an issuance because the new shares would dilute management’s holdings in the investment. So the answer can be to use something that looks like debt from the issuing company’s perspective, but is treated as equity in the other country.

Advance Rulings

In some countries it is possible to get an advance ruling from tax authorities in the foreign country, so that you know ahead of time how the instrument will be treated. For example, we have worked on deals where the client has received rulings in Luxembourg for issuance of hybrid instruments. CThe advisors can meet informally with the tax inspector and discuss the transaction and then counsel can make changes required by the tax inspector, and subsequently obtain a binding written ruling. This is a much more expedited process than in other countries, where it takes three to nine months to get a ruling.

Meeting the Requirements of the Foreign Jurisdiction

In order to know the kind of terms the hybrid instrument will need to be treated as debt in a foreign jurisdiction, Fidelitas works carefully with local advisers to tailor the instrument to local requirements. We work with local counsel to draft the instrument in a way that is designed to meet the particular criteria in the foreign country to qualify as debt.

Fidelitas, when designing hybrid instruments, takes in account the following:

• Types of structures (e.g. companies, branches and hybrid entities) and tax planning techniques
• Distinctive elements in the determination of debt and equity
• Participation in profits
• Maturity
• Ranking of the capital (tax issues v. regulatory issues)
• Accumulation of the payments
• Tax, regulatory and corporate advantages in issuing hybrid financial instruments
• Anti-Avoidance Issues, like thin capitalization rules, CFC legislation and internatonal tax arbitrage