A HYBRID financial instrument is a financial security that combines the features of both debt and equity.
These instruments are widely used across corporate finance, investment structuring, tax planning and regulatory capital (banking and insurance) to optimise the financial performance, reduce risks and increase flexibility to the issuer and the instrument holder.
The tax treatment of hybrid financial instruments is subjective. The decision on whether the instrument is debt or equity will be based on the features of the instrument. The underlying principle here is whether the payment of distribution of profits will be tax deductible. If it is debt, it is tax deductible, but if it is equity, it is not tax deductible.
The common examples of hybrid instruments in the marketplace are redeemable preference shares, convertible bonds and loan notes, perpetual bonds, mezzanine financing, profit participating loans, warrants and hybrid sukuk.
Distinction between debt and equity
To distinguish whether a hybrid financial instrument falls within the equity or loan bucket for tax purposes, it is vital to examine the legal rights and obligations created by the instrument for the issuer and the instrument holder and the facts and circumstances surrounding the instrument to understand the underlying true nature of the instrument.
Transactions between third parties would be conducted under a caveat emptor (buyer beware) principle. In most cases, the underlying purpose of issuing these instruments would be evident from the legal document unless there is collusion between the parties. However, in related party transactions, greater scrutiny would be required to determine the substance of the transaction as the issuer and the holder are not deemed to be undertaken on an arm’s length basis. The burden of proof lies with the taxpayer to show that the transaction was done on an arm’s length basis.
The most important feature of an equity instrument would be the absence of any guarantee of the repayment of principal or distribution of profits, and any such repayments will be dependent on the profitability of the company. Equity holders will have the right to vote. In the event of liquidation, the equity instrument will have a lower level of priority compared to the creditors or any other debt instruments. The equity holder will face a higher risk compared to the holder of debt. Equity holders do not have any guarantee of fixed returns or distributions, and there will be no fixed repayment dates. Equity holders can participate in the management of the company. The equity holder invests in an instrument with the expectation of participation of profits and long-term capital appreciation of the investment.
Convertible instruments such as convertible redeemable preference shares which can be converted into equity are instruments that may contain both equity and loan features where in the initial years, the coupon payments are guaranteed, and thereafter upon conversion, such payments are no longer assured and begin to adopt features of an equity.
In such instances, to determine whether the instrument is a loan or equity, it is important to scrutinise the legal documents which will state the rights and obligations of the issuer and the holder. It is possible that before the conversion, the holder of the instrument may not be entitled to vote or participate in the management, and may be given priority on any distribution in the event of any liquidation. The same instrument upon conversion will have more features akin to equity.
In such cases, the tax treatment can change as the nature of the instrument changes its character. Initially it can be treated as a debt, and thereafter once the instrument is converted, it can be treated as equity.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (www.thannees.com).