A Study into Debt and Equity Classification the UK Tax Deployment of Hybrid Securities (2010)

Hybrid financial instruments have been utilised for centuries but have been deployed to the international capital markets in the 1980’s as the same time as the market developed high yield debt, zero coupon debt. Moreover, the main objectives of the corporations to issue hybrid securities in the early days were (i) to meet specific gearing ratio, (ii) shareholders and voting structure of the company, (iii) current market conditions such as interest rates, exchange rates (iv) tax treatment of issuers and investors (v) capital requirement and stock exchange requirement. Hybrid securities have become fashionable among banks and insurance companies as a consequence of the regulatory capital adequacy imposed on banks which was issued by Basel Committee in late 1998. This regulatory allows a maximum of 15% of Tier 1 capital to be in a form of “innovative tier capital” which has a main characteristic as non-cumulative preference shares which is able to absorb losses within the bank but still contains expense deductibility on interest paid. For non-financial corporate sector, the use of hybrid soared since February 2005 when Moody's announced a new rule of rating treatment to hybrid capital by giving more equity rating to some certain types of hybrid capital. The new methodology is to divide the securities into five baskets along the debt-equity continuum. The most popular hybrid falls into Basket D and will be treated as 75% equity and 25% debt credit. To be qualified in this basket, the security has to contain some equity characteristics such as having no maturity date, being non-call for five to ten years and having interest deferral while still preserves an advantage of debt trait such as no dilution to shareholders’ interest and being cheaper than equity capital. Chapter 1 The use of hybrid securities and credit rating perspective What are hybrid securities? The nature of equity and its replication in hybrids Special feature: Payment in shares The nature of debt obligation and its replication in hybrids Why issue hybrids? – An issuer’s perspective Why invest in hybrids? – An investor’s perspective Why use hybrids? – Taxation perspective Chapter 2 Domestic tax law classification and tax treaty classification Overview Domestic tax law classification First method: Integration Second method: Bifurcation Thin Capitalisation classification Cross-border situation Tax treaty classification Dividend definition Interest definition Double taxation relief Chapter 3 UK tax law classification Overview Tax treatment of interest paid.