QUEEN MARY, UNIVERSITY OF LONDON LAW DEPARTMENT

LL.M in Taxation Law

DEBT AND EQUITY CLASSIFICATION OF HYBRID SECURITIES AND THE UK TAX TREATMENT ON HYBRID SECURITIES

Examination Number: LD227 Supervisor: Dr. Christiana Panayi

Number of words: 13,475 Date submitted: 18th August 2008

Contents

Abbreviations and References Introduction

4 5

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

8 8 9 12 13 14 15 15

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

18 18 19 19 21 22 23 24 25 27 28

Chapter 3 UK tax law classification Overview Tax treatment of interest paid

30 30 32

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Application of integration method: Reclassification of payments Application of bifurcation method UK Thin Capitalisation classification Accounting classification Consequences of classification under integration method Consequences of classification under bifurcation method: Convertible bonds Application of withholding tax

32 34 35 35 36 39 41

Conclusion Bibliography

43 45

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Abbreviations and References

FA FRS GAAP HMRC IAS ICTA ITA ITTOIA OECD OECD Model

= = = = = = = = = =

Financial Act Financial Reporting Standard Generally Accepted Accounting Principles Her Majesty’s Revenue and Customs International Accounting Standard Income and Corporation Taxes Act 1988 Income Tax Act 2007 Income Tax (Trading and Other Income) Act 2005 Organisation for Economic Co-operation and Development OECD Model Tax Convention on Income and on Capital

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DEBT AND EQUITY CLASSIFICATION OF HYBRID SECURITIES AND THE UK TAX TREATMENT ON HYBRID SECURITIES

INTRODUCTION

Hybrid financial instrument have existed for centuries1 but have been introduced to the international capital markets in the 1980’s as the same time as the market developed high yield debt, zero coupon debt.2 Basically, 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.3

Hybrid securities have become popular among banks and insurance companies as a consequence of the regulatory capital adequacy imposed on banks which was issued by Basel Committee in late 1998.4 This regulatory allows a maximum of 15% of Tier 1 capital to be in a form of “innovative tier 1 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

A feature of preference was used in an instrument issued by English company in the middle of 16th century. Following that period, in 17th and 18th century, convertible securities were probably first used. Dewing, A. (1934), A Study of Corporation Securities: Their Nature and Uses in Finance, New York: Ronald Press. 2 Hariton, D. ‘Distinguishing Between Equity and Debt in the New Financial Environment’ (Spring 1994), 29 Tax Law Review 499-524, at 499. McCormick, R. and Creamer, H. (1987), Hybrid Corporate Securities: International Legal Aspects, London: Sweet & Maxwell, at 3. 4 Basel Committee on Banking Supervision Press Release, ‘Instrument eligible for inclusion in Tier 1 Capital’, < http://www.osfibsif.gc.ca/app/DocRepository/1/eng/notices/bis/rel_e.pdf>, accessed 27 June 2008.
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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 5 while still preserves an advantage of debt trait such as no dilution to shareholders’ interest and being cheaper than equity capital.

Apart from regulatory and credit rating consideration, accounting classification is one of the factor that the issuers of hybrid securities have to consider since the numbers in company’s accounts show the financial position of the company. Issuers of hybrid securities generally prefer their issued hybrid securities to be classified for accounting purposes as equity because the excessive debt reduces the credit rating of the company and the interest payment arising from debt capital reduces the net income.

While ratings agency classification and accounting classification focuses on the effect of the security on the issuer’s capital structure and cash flows, tax classification more focuses on the rights of the holders of the hybrid security as compared to the rights of the issuer’s other security holders.6 This difference provides the taxpayer an opportunity to cut some percent off from their tax bill by carefully structuring hybrid securities. Basically, this can be done by designing an instrument that is regarded as equity for credit rating and accounting purposes without losing the ability to qualify as debt for tax deductions from interest payable. Moreover, the difficulties have been posted to the Revenue Authorities of many countries in the case of innovative hybrid securities. Many new financial instruments have been designed not to fit into any traditional tax treatment but straddle on or very close to the debt/equity boundary. 7 Revenue Authorities of many countries do not come with the clear guidance which instruments will be treated as debt or equity. This creates an immense tax uncertainty for issuers and investors. Consequently, when instruments that have very similar economical characteristics can be treated differently for tax purposes, opportunity for tax avoidance and tax

5

Pinedo, A. ‘Next Generation Hybrid Securities’ (May 2006), 10 Wall Street Lawyer, No.5, <http://www.mofo.com/practice/docs/WSL10.pdf>, accessed 15 July 2008. 6 Ibid. at 2
7

Duncan, J., International Fiscal Association (2000), Cahiers de droit fiscal international/ Studies on International Fiscal Law: General Report on Tax Treatment of Hybrid Financial Instruments in Cross-Border Transactions, Munich: Kluwer Law International, at 24.

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arbitrage will be created.

An opportunity for tax avoidance is even greater in the context of cross-border payment, where the same or similar hybrid instruments are taxed differently in the borrower and in the investor country. This conflict is referred to as a “qualification conflict”.8 This inconsistency in characterization creates problems when the payment of interest is tax-deductible in the borrower’s jurisdiction and when the laws of the country of residence of investors classify that instrument as equity, and the payments consequently treated as dividends which are tax-exempted under exemption with participation regime.

To sum up, the differences in the debt and equity classification methodologies for regulatory, credit rating, accounting and tax purposes is a main factor that promote a use of hybrid securities among issuers and investors as a tool to tax avoidance and tax arbitrage. Therefore, this dissertation will focus on addressing those differences in debt and equity classification principles by focusing on the classification for tax purposes. In the last chapter of the dissertation, UK tax treatment of hybrid security is used as an example of tax classification.

Russo, R. (2007), Fundamentals of International Tax Planning, Amsterdam: International Bureau of Fiscal Documentation (IBFD), at 125.

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CHAPTER 1

DEBT AND EQUITY CLASSIFICATION: THE USE OF HYBRID SECURITIES AND CREDIT RATING PERSPECTIVE

1.1. What are hybrid securities?
A financial instrument that has a hybrid nature was defined in the International Fiscal Association general report as “a financial instrument that has economic characteristic that are inconsistent, in whole or in part, with the classification implied by legal form. Such an instrument may possess characteristics that are consistent with more than one tax classification, or that are not clearly consistent with any classification.” 9

Hybrid securities,10 or debt-equity hybrid instruments, as a subset of hybrid financial instruments,11 are generally defined as securities that combines both debt and equity characteristics. The most common forms of hybrid securities are preferred equity, convertible debt and subordination and perpetual debentures for banks and insurance companies.12

In most of transactions, instruments have been designed to have equity characteristics to serve the regulatory requirements, credits ratings and financial accounting purposes while having a legal form as debt obligation in order to secure the benefit of interest deductibility for tax purposes. To understand the characteristics of hybrid securities and their benefit to issuers and investors, it is important to initially address a nature of equity that is replicated in hybrid securities.
9

Duncan, supra footnote 7, at 22

Hybrid securities is also called as “hybrid capital”, “hybrid bonds”, “enhanced capital advantaged preferred securities” (ECAPS), “subordinate lien general revenue bonds”. Carey, A., ‘Hybrid Capital: A Serious Alternative for Corporates?’ (2006), Lovells Client Note, <http://www.lovells.com/NR/rdonlyres/FBF41FFA-338B-4A909FADC10AD5248DBA/0/3596_F2.pdf>, accessed 5 July 2008. 11 Hybrid financial instruments are instruments that combine two or more different element. These instruments include a bond with equity features, a share with debt characteristics and debt instruments that contain an embedded derivative (contingent payment debt). Edgar, T. (2000), The Income Tax Treatment of Financial Instruments: Theory and Practice, Toronto: Canadian Tax Foundation, at 243. Also see Weisbach D., ‘Tax Responses to Financial Contract Innovation’ (Summer 1995), 50 Tax Law Review, 491-544, at 496-502. 12 McCormick, supra footnote 2, at 51.

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1.2. The nature of equity and its replication in hybrids
Professor Southern suggested the best way to describe the nature of equity by considering the German term “Eigenkapital” which means internal finance as opposed to “Fremdkapital” or external finance to describe debt securities.13 The distinction is, shareholders provide equity capital in exchange for share in the company with an intention to take a risk and to enjoy a chance of profit from business venture. On the other hand, the only purpose of the creditors is to lend the moneys to the person who needs them.14

According to Shelton, this main distinction leads to the characteristics that suggest equity including the following: 1. no right to a fixed return; 2. participation in profits; 3. no right to a return of capital investment before liquidation; 4. indefinite term; 5. the absence of security; 6. most subordinated; 7. the distribution from equity capital is not an expense for an issuer; 8. the dividend will be charge to tax as income when it is paid or declared; 9. a gain on disposal of shares will be taxed under capital gain tax regime. 15

From credit rating perspective, these characteristics can be summed up into three features of equity that hybrids try to replicate; no ongoing payments, no maturity and loss absorption.16

Southern, D. and PricewaterhouseCoopers’ Treasury Tax Team (2007), Taxation of Loan Relationships and Derivative Contracts, West Sussex: Tottel Publishing. at 4 14 Hariton, supra footnote 2, at 499.
15 16

13

Shelton, N. (2004), Interpretation and Application of Tax Treaties, London: LexisNexis, at 508.

Moody’s Rating Methodology, ‘Moody’s Tool Kit: A Framework for Assessing Hybrid Securities’ (December 1999).

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1.2.1. The replication of ‘no ongoing payments’ feature
Dividends are only payable only out of realised profit.17 An issuer is not bound to pay a certain ongoing amount of dividend to ordinary shareholders (or as common stockholders in the USA). Two features adapted from this nature are (i) interest deferral, and (ii) participation in profit.

When an instrument contains deferral features, the issuer can postpone the payment of interest of preferred dividend upon some certain situation such as negative operating result. Deferred payments can be cumulative or non-cumulative. The cumulative normally accrue interest.18 When the payment of interest of dividend is deferred, the payment of common dividend is normally suspended simultaneously until all deferred payments are made. In preferred stock, the deferral does not trigger an event of default even when the payment is deferred indefinitely which is different from that in trust preferred securities19 issued in the US which have a deferred payment time limit of five years.

Some types of equity-like debt provide a payment that is linked to an amount of dividend payments. Even though this feature is not commonly found in public market, it is rather popular in private sectors and a number of tax treaties set out the rules in order to determine whether the payment of such instrument is dividend or interest.20

Credit rating’s perspective
Under Moody’s recent methodologies in assessing hybrid instrument, the securities that have a term of mandatory or automatic deferral of interest payment will generate a score of strong while the securities with optional deferral features are categorized as “moderate”. It is important to note that these rakings is based on an assumption that the payment is non-cumulative deferral structure because it replicates ordinary shares more closely than a cumulative deferral since unpaid common dividends do not accrue.

17 18 19

Company Act 1985 s 263 Pinedo, supra footnote 5, at 3

Trust preferred securities or trust preferred stock is an innovative form of preferred stock. Trust preferred stock produces the more favorable tax treatment to the issuer of an instrument because US tax authority treats the payment of such instrument as tax deductible while an instrument still maintain the classification as equity for regulatory, credit rating and accounting purposes. 20 Duncan, supra note 7, at 25

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1.2.2. The replication of ‘no maturity’ feature
An instrument can replicate this feature by having long or perpetual term (no fixed redemption date). As seen in many jurisdictions, instruments can be designed to have no maturity or having a maturity that correspond to the life of the company or having an extremely long maturity such as Lehman brothers E-CAPS with 60-year term.21 During its lifetime, there is still on going interest obligation that can always trigger an event of default if issuer misses to pay an interest.

Most of perpetual securities are callable on the issuer’s option (an issuer has the right to redeem the bond early). This usually happens when the interest rates in the market is becoming lower, therefore; a company uses this opportunity to refinance its capital.

Credit rating’s perspective
It is always a problem to distinguish between an extremely long dated security and a perpetual security for tax purposes. Credit rating agency such as Moody’s stated that a security with an extremely long maturity and no ongoing amortization requirements may offer the same quality of capital as a perpetual security.22 It continued applying a fact and circumstances test to define the term “extremely long dated”. The factors used to consider are, for example, maturity of the issuer’s other debt, industry practices and company-specific factor such as the issuer’s status on rating spectrum.

Moreover, a likelihood of the company to refinance is another factor that affects company’s credit rating. Moody’s ranks an instrument which has no maturity with issuer’s call option as “weak” while giving an instrument that provides a replacement of security which has similar or more equity-like security when call option is exercised by the issuer a “moderate” credit.

1.2.3. The replication of ‘loss absorption’ feature
Ordinary shareholders are the holder of residual value in a company. This means that, in an event of liquidation or bankruptcy, ordinary shareholders will not receive their capital payment until the holder
21 22

Pinedo, supra footnote 5, at 4. Moody’s Rating Methodology, supra footnote 16, at 6

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of other class of securities have been paid. Thus, it can be said that ordinary share is a security that has a highest ability to absorb loss. This ability leads to the concept of subordination. Debt obligation can be designed to be preferred or subordinated. Thus, when thing goes wrong, preferred or subordinated debt will be deemed inferior to other class of debt but has a seniority to capital payment superior to ordinary shareholders. There have been a lot of effort to develop and instrument which can narrow the gap between the most subordinated debt obligation and the most senior equity security in order to secure tax benefit of interest payment. 23

Credit rating’s perspective
The Moody’s refinements now characterize preferred securities and certain types of subordinated debt as “strong” (rather than “moderate”) in recognition of their loss absorption characteristics. 24

1.3. Special feature: Payment in shares
In some countries, it is possible to design an instrument in which, on the maturity date, provides payment for debt obligation by a fixed number of the issuer’s common shares. This feature of conversion can comes in two form; mandatory and optional conversion.

In mandatory convertible securities, the holder must convert the mandatory convertible into the underlying ordinary shares, normally within a relatively short time of three to five years.
25

On the other hand, optional conversion to common share is one of the most common and the oldest form of attached to hybrid debt security.26 It can be found in convertible debt and preferred stock. Like other ordinary bonds with no conversion right, convertibles carry right to coupon payments, repayment of principal on maturity while providing additional feature for the holder of debt instrument an option
23 24 25 26

Duncan, supra footnote 7, at 25. Pinedo, supra footnote 5, at 5. Moody’s Rating Methodology, supra footnote 16, at 7.

Bratton, W., ‘The Economics and Jurisprudence of Convertible Bonds’ (1984), 3 Wisconsin Law Review 667740, at 667.

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to convert into a predetermined numbers of fully paid shares of issuing company at a given price in any given time. The expectation of the investor is that the issuing company will prosper and share price will rise and exceed than conversion price. On the contrary, if the share price goes down, the investor can choose not to convert debt obligation to shares and expect the fixed income arisen from the use of his/her capital.

Credit rating’s perspective 27
If the terms of convertibles are appropriately tailored, corporate credibility can be enhanced. According to Moody’s tool kit, an instrument in E basket, which will be treated as 100% equity, has to comprehend five core elements which are (i) mandatory convertible (ii) convertible within three years (iii) subordinated debt or preferred or senior with accelerated conversion (iv) optional deferral and (v) cumulative coupon. Mandatory convertible securities are placed as highly equity-like than optional convertible securities and consequently gains better credit rating. The reason is that it shows that the company has an intention to raise a fixed amount of common equity and that the company does not have a policy to refinance its capital structure. In addition, it provides the company a certain cash flow since there is no repayment in the future.

On the other hand, when the possibility to convert debt into shares lies on the investor’s options, the issuer’s operating performance and stock market conditions play a great role on investor’s decision. This causes uncertainties which makes optional convertibles securities receive less equity benefit at the time of issuance from credit rating agency.

1.4. The nature of debt obligation and its replication in hybrids
To avoid being considered as thinly capitalised, a corporation can issue equity securities which have some debt features and fewer equity characteristics. Non-participating preferred stock provides the holders to receive a regular specified dividend at fixed or floating rate and have no rights to participate in the profit of business. In some countries, preferred stock can be designed to be closer to indebtedness

27

Moody’s Rating Methodology, supra footnote 16, at 7.

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by providing the terms of mandatory redemption after a short term.28

1.5. Why issue hybrids? - An issuer’s perspective 1.5.1. An instrument with interest deferral term
In banking and financial industries, according to Moody’s report, an instrument which has a deferral term is not widely used since it damages the reputation of issuers which consequently has an effect to the confidence of short-termed investors. This type of term, instead, is used among lower grade of company who emphasize more on the financial need to defer payments of interest than the creditability of company. Thus, this type of instrument normally offers high-yield return.

1.5.2. An instrument with long or indefinite term
Most of perpetual debt obligation are deeply subordinated issued by banks and other regulated entities in order to satisfy capital requirement.

1.5.3. Subordinated debt and preferred share
The reasons that subordinated debt may be preferred is that issuer company does not have to comply with strict provision relating to issuing of new shares and repayment of equity capital. Moreover, it does not dilute shareholders’ interest.29 For Banks, subordinated perpetual debt securities have a great attraction for regulatory purpose.

1.5.4. Convertibles
According to Investopedia, issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions.30 For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat

28 29 30

Duncan, supra footnote 7, at 26. McCormick, supra footnote 3, at 51. Investopedia, ‘Convertible bond’,< http://www.answers.com/topic/convertible-bond>, accessed 20 July 2008.

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overvalued.31 To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway if the company continues to do well.32

As convertibles can be described as a non-convertible bond with embedded stock options, convertibles normally yield a low coupon rate in exchange for the value of the option to convert the bonds into stocks. This makes it attractive to issuers. However, in exchange for that benefit, in most jurisdictions, including the UK,33 convertibles are treated as share for company law purposes which means that they create the shareholders’ stock dilution when the holder converts bonds into shares.

1.6. Why invest in hybrids? - An investor’s perspective
The holders of subordinated loans, perpetual debentures, or of instruments with interest deferral term are normally compensated for an extra risk by a higher yield than holders of traditional debt securities. Therefore, it is essential for investors to purchase hybrid securities issued by high-grade companies which are less likely to default.34 In reality, companies issuing hybrids can avoid paying such a high return to outside investors by acquiring loans with such terms from major shareholders and parent companies.

1.7. Why use hybrids? – Taxation perspective 1.7.1 Tax deductibility of interest expense

It has been a long established principle that when the company pays the money for the use of resources provided by outside investor such as equipment, intellectual property or even outside loan, the expense for the use of those resources is tax-deductible. 35 As interest is an expense for the use of external

31 32 33 34 35

Ibid. Ibid. Convertibles are treated as ‘relevant securities’ for Companies Act 1980 s 80. Carey, supra footnote 10. Duncan, supra note 7, at 107.

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finance, it is generally deductible by the payer. Dividend,36 on the other hand, is paid out of profit so is not tax deductible but frankable in the countries with imputation system such as Australia.37

In cross-border situation, tax planners will choose a hybrid security that is considered to be debt at the hand of issuer but equity for the investor in the case that dividend income will be tax exempted within participation exemption regime or carrying double tax credits.

1.7.2. Application of withholding tax
Withholding taxes on interest payment are often reduced or eliminated by a number of double taxation treaties.38 Therefore, interest payment made to non-resident investor is not subject to withholding tax while generally is in the case of dividend payment.39 The difference can be found in some jurisdictions, for example Brazil, India, the United Kingdom and, in some circumstances, China, dividend payment made to non-resident corporations is free of withholding tax but is not on interest payment.40

1.7.3. The derivation of taxable income
The payment of dividend is considered as taxable income only when paid or declared. On the other hand, the return from debt obligation will be taken into account for tax purposes for both issuer and investor on an accruals basis and in some case without considering whether the payment will ultimately made or not.

1.7.4. Capital gains tax liability
The return on debt obligation such as interest or discounts is taxed as interest income while the return

36

In some countries, dividend payment is tax deductible. For example, Brazil has a limit of dividend deduction up to the amount equivalent to a notional amount of interest on the company’s equity. Duncan, supra footnote 7, at 107. 37 Wood, R., ‘The Taxation of Debt, Equity, and Hybrid Arrangement’ (1999), 47 Canadian Tax Journal, 49-80, at 51. 38 Southern, supra footnote 13, at 477.
39 40

Duncan, supra footnote 7, at 27. Russo, supra footnote 8, at 107.

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on equity capital can be divided into two types of return; dividend and the disposal of share capital. The former will be subject to tax under income tax regime while the latter will be taxed under capital gains tax regime.

1.7.5. Corporate group structure
The issuance of equity can affect the group structure of the business. Apart from commercial attractions of group structure, corporate entities in the group can enjoy the benefit from loss relief carry over to other entities in the same group. Forming the group may carry some disadvantages, for example, in an application of small companies’ rate of tax to the member of the group. Thus, a company who is funded by outside investor may issue debt obligation that carry a right to participate in the profit to secure its previous or favorable corporate group structure.41

1.7.6. Thin Capitalisation rules and Exchange control regime
A company will be considered as ‘thinly capitalised’ when the ratio of intra-group loan to equity capital exceeds a favorable ratio set out by Revenue Authorities. Hybrids are designed to be as close as possible to the borderline between debt and equity in order to disguise its substance and provide its issuer avoidance from thin capitalisation rules.

In countries such as China and India, exchange control regime is applied to restrict the leverage in local subsidiaries of foreign multinational enterprises.42 As a consequence, there is a need for exchange control approval in order to acquire foreign borrowings.43 Again, hybrid securities can be used to avoid the application of such regime.

41 42 43

Duncan, supra footnote 7, at 28. Russo, supra footnote 8, at 110. Ibid.

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CHAPTER 2

DEBT AND EQUITY CLASSIFICATION: DOMESTIC TAX LAW CLASSIFICATION AND TAX TREATY CLASSIFICATION

2.1. Overview
When it comes to the question of determining the tax treatment of traditional debt or equity capital, the starting point is to look at company law. Instrument with the legal form of share will normally be taxed as such. Legal distinction is broadly followed by accounting and tax rules but in some particular circumstances, economic distinction is applied. In many countries, legal form of hybrid securities is rejected by the courts and revenue authorities because it does not provide a substantive classification of sophisticated financial instrument.44 As a consequence, a set of reclassification rules have been enacted as a legislative response to tackle this problem, for example, special provisions dealing with preferred shares and convertible debt in Canada and Austria,45 the reclassification of debt as quasi-equity in the UK or a notice46 by US tax authorities providing a set of detailed rules to tackle an instrument that is designed to be treated as debt for tax purposes but as equity for regulatory, rating agency, or financial accounting purposes. This shows that judicial and legislative branches in a number of countries have been trying to identify whether one hybrid security is debt or equity by treating it as a unit. This is called ‘integration approach’. Some academics have proposed a ‘bifurcation approach’ in order to deal with a more complex hybrid instrument including hybrid securities. Under bifurcation approach, hybrid securities would be split into more traditional components, debt and equity.

44 45 46

Edgar, supra footnote 11, at 305 and footnote 283 of chapter 6. Ibid., at 305 and footnote 284 of chapter 6. Notice 94-47, 1994-19 I.R.B. 9, 1994 WL 132052 (IRS ANN), 1994-1 C.B. 357. (hereafter ‘Notice94-47’)

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2.2. Domestic tax law classification 2.2.1. General classification approaches 2.2.1.1. First method: Integration 47
Integration was best described by Weisbach as a system of taxation that treats two or more positions as a unit to determine the tax on the positions.48 According to the General Report on Tax Treatment of Hybrid Financial Instruments in Cross-Border Transactions,49 most of reporting countries apply this method instead of bifurcating instruments into smaller components and tax them separately.

The method of integration is implemented through one of three general approaches, all of them are based on the legal rights and obligation of the holder of an instrument.

Under the first approach, terms of the instrument and all facts and circumstances are used to identify whether an instrument has more debt or equity characteristic in order to categorize it as wholly debt or wholly equity. 50 This approach has been opposed by some academics as it cannot deal with the innovative financial instruments. 51 The reason is that there is no weight given to any particular factor under fact and circumstances test. This causes difficulties to the court and Revenue Authorities to classify complex hybrid securities. The problems become more severe when an instrument is designed to be closest to debt and equity boundary. In addition, complicated terms and conditions contained in a sophisticated instrument will result in the rulings used to classify hybrids as debt or equity to become more lengthy, complex and impenetrable. It can be concluded that an implication of facts and circumstances test poses a substantial uncertainty to investors and issuers of hybrid securities.
47

This method is sometimes called a ‘blanket approach’, ‘debt and equity characteristics approach’, ‘reasoning by analogy approach’ or an ‘all-or-noting approach’. 48 See Weisbach, supra footnote 11.
49 50

Duncan, supra footnote 7.

An example of facts and circumstances test is the application of notice 94-74 by US tax Authorities, (a) whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date; (b) whether holders of the instruments possess the right to enforce the payment of principal and interest; (c) whether the rights of the holders of the instruments are subordinated to rights of general creditors; (d) whether the instruments give the holders the right to participate in the management of the issuer; (e) whether the issuer is thinly capitalized; (f) whether there is identity between holders of the instruments and stockholders of the issuers; (g) the label placed upon the instruments by the parties; and (h) whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes. 51 See Kleinbard, E., ‘Equity Derivative Products: Financial Innovation’s Newest Challenge to the Tax System’ (May 1991), 69 Taxes Law Review, 1319-1368, at 1335.

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An improvement of this approach has been proposed by Hariton.52 He stated that it is not possible to characterize an instrument as equity or debt by reference to a checklist of abstract attributes. The reason is that a single abstract attribute can be describe as many separate attributes to create more weight to support either tip of debt-equity scale. He, then, focused on the truth that debt obligation is designed to give the investor a return that does not vary with the issuer’s profits. Therefore, the question is scoped down to the risk and reward from the issuer’s business that the investor has comparing to other classes of investors in the same company. This classification can be achieved by asking the questions such as: (1) How much equity capital supports the investor’s right?; (2) How much debt capital is senior to it?; (3) To what extent will the investor participate in the issuer’s profits?; (4) What rights, if any, will the equity still have if the lender loses money?53

The problem of uncertainties caused from weighting up a number of factors from above mentioned facts and circumstances test can be removed by the second approach where a single determinative factor is used to identify whether an instrument is debt or equity. This bright line test is applied by using a particular right and obligation as a determinative factor. An application of a bright line test can be found, for example, in the UK’s, Australia and Canada’s rules relating to preferred share and Australia. 54

The third approach can be considered as an extreme version of bright line test. This approach was proposed by Emmerrich in 1985 by moving the boundary of debt and equity to either the debt end or

52 53 54

Hariton, supra footnote 2. Ibid., at 521-23.

The preferred shares rules in Canada set out four single determinative factors as to treat a share as debt instrument. Those four factors are (i) a redemption right, (ii) a fixed dividend or liquidation entitlement, (iii) a guarantee of dividend or capital payments, or (iv) a right of conversion into an instrument other tan certain fully participating shares. An instrument that contains even only one single term of the terms stated above will be treate as debt for tax purposes. In Australia, The Australian tax authorities recommended a basic classification using legal form but an instrument with a legal form as equity can be treated as debt if it provides a “contractually guaranteed return of the original investment.” The instrument will be considered as “contractually guaranteed” if it has a term of 20 years of less. Edgar, supra footnote 11, at 306.; also see Australia, Review of Business Taxation (1999), A Platform for Consultation - Building on a Strong Foundation: Overview of the Taxation of Investments, Discussion Paper 2, Vol. 1, Canberra: Australian Government Publishing Services, at 202.

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equity end.55 For example, when the debt-equity boundary is moved to be closer to the debt end, a very clear and precise definition of debt must be defined56 and the tax treatment of debt and equity must be restricted. 57 Emmerrich proposed that debt could be defined as an instrument with unconditional promises to pay the return to the holder of debt instrument a certain sum of money on a specific date.58 Then, the accrual basis of accounting will be applied to the deduction and inclusion of fixed payments that arises from the instrument that is accordance with the definition of debt and all other hybrid arrangement will receive dividend tax treatment.59 On the other hand, the borderline can be moved to the equity tip. In that case, the definition of equity must be defined. This method will help abolish the uncertainties and complexity arising from the previously mentioned method of integration but still contains some drawbacks as it composes the discontinuity. Similar to the basic version of a bright-line test, the fact that this extreme treatment separates the debt (or equity) from the whole hybrid instrument by using one determinative factor makes it unable to apply the tax treatment that fully consistent with their economical characteristics.60 This discontinuity has become a device for tax planning using hybrid instruments.61

2.2.1.2. Second method: Bifurcation
This method was proposed to eliminate the problem of uncertainties and discontinuities created by integration approach. The method of bifurcation can be separate into two main methods, single and dual bifurcation.

Under single bifurcation, hybrid instrument will be broken into two or more components and each component will be taxed separately by reference to basic tax treatment of each unit.62 Weisbach gives an example of two similar cash flows with different arrangement; (i) a debt instrument and a separate
55

See Emmerich, A., ‘Hybrid Instruments and the Debt-Equity Distinction in Corporate Taxation’ (Winter 1985), 52 The University of Chicago Law Review, 118-148, at 120. 56 Wood, supra footnote 37, at 61.
57 58 59 60 61 62

Edgar, supra footnote 11, at 306. Emmerrich, supra footnote 55, at 143. Edgar, supra footnote 11, at 306. Wood, supra footnote 37, at 61. Edgar, supra footnote 11, at 306. Weibach, supra footnote 11.

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cash-settled forward contract to purchase the stock of X company, (ii) a single security of a fixeddividend payment with contingent payment at maturity linked to the value of the stock of X company. Under bifurcation, the second instrument will be bifurcated as a fixed rate debt instrument and a cashsettled forward contract identical to the tax treatment of the first cash flow. On the contrary, under the integration method, the latter instrument, despite the contingent payment at maturity, can be fall into the debt category. It can be seen that integration method gives taxpayers choices of tax treatment for the same cash flows. From the second example, if treating the whole instrument as debt is not beneficial, taxpayers will separate the instrument into a debt instrument and a forward contract.

Bifurcation has been criticized by a number of academics.63 The main reason is that, to create one certain type of cash flow, different components can be used 64 and for one given instrument of combined components, there is no unique bifurcation.65 The different bifurcations can produce different tax attributes that attach to any financial instrument.66

Practically, the use of bifurcation is limited to bifurcate securities that are convertible into or exchangeable for shares into a straight-debt instrument and an embedded equity option, or securities which are linked to the value of other assets.

2.2.2. Thin capitalisation classification
According to the General Report on International Aspect of Thin Capitalization,67 measures that are used in the reporting countries to identify the tax treatment of financial instruments under thin capitalisation rules can be divided into three following categories:

63

Ibid., at 493; See e.g. Strand “Taxing New Financial Contract Innovation”; Kau, R., ‘Carving Up Assets and Liabilities-Integration or Bifurcation of Financial Products’ (1990), 63 Taxes 1003; Harriton, D., ‘New Rules Bifurcating Contingent Debt – A Mistake?’ (April 1991), 51 Tax Notes, 235-239. 64 Duncan used convertible debt as an example. Convertible debt can be created as a non-convertible debt instrument embedded with an option to acquire shares or be acquiring shares and entering into a put option to sell those shares on the maturity date of debt obligation. He, then, referred to the illustration given by Kau. In Kau’s article, he showed that, to imitate one specific cash flow, there are, at least, 13 different ways to do. 65 Weisbach, supra footnote 11, at 493.
66 67

Wood, supra footnote 37, at 62.

Piltz, D., International Fiscal Association (1996). Cahiers de droit fiscal international/ Studies on International Fiscal Law: General Report on International Aspect of Thin Capitalization, Geneva: Kluwer Law International.

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(1) countries with particular rules on thin capitalisation; (2) countries with general rules which also apply to thin capitalisation; (3) countries without thin capitalisation regulations.

In the countries that have particular rules on thin capitalisation, the following concepts have been adopted: (1) Fixed debt to equity ratios;68 (2) Reclassification of interest payable to non-residents;69 (3) Rules on thin capitalisation for particular industries;70 (4) Consolidation and thin capitalisation;71 (5) Rules on thin capitalisation relating to managing directors.72

However, in the countries that apply general tax rules on thin capitalisation, the principles such as: (1) Substance over form;73 (2) Arm’s length principle;74 and (3) The abuse of law concept,75will be applied.

2.2.3. Cross-border situation
As a general rule, in a cross-border situation, there is no obligation for the investors to follow the
68

Under this concept, the specific maximum debt to equity ratio (‘safe haven’) is imposed. An excess shareholder debt financing over this ratio will be penalized for tax purposes. Ibid., at 100. 69 See below at page 35 for UK thin capitalisation rules. In Norway, the safe haven ratio of 4:1 is applied only for oil and natural gas companies operating on the continental shelf. See Piltz, supra footnote 67, at 100. 71 Denmark limits interest deductions for holding companies if taxed on a consolidated basis with other affiliated companies. Ibid. 72 In Belgium, there is a limitation that the total loan from the managing director of a company cannot exceed the amount of equity capital. Ibid. 73 Under this principle, loan capital provided by shareholder can be reclassified as equity when: (i) there are no fixed provisions for repayment; (ii) Interest depends on profits; (iii) the loan is convertible into a share of the company’s equity; (iv) the equity ratio is significantly below the industry average; (v) there is a clear disparity between equity ratio and company risk; (vi) there is no possibility of obtaining loans from unrelated persons. Ibid. 74 Under this principle, the interest rate of the loan capital provided by shareholder will be adjusted if exceeds the normal interest rate provided to the company, in the same circumstances, by unrelated parties. Ibid. 75 The countries applying this concept consider that excessive loan financing of a subsidiary company by its nonresident shareholder is a misuse of the available legal options with the aim of reducing the tax burden in the source country. Ibid.
70

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classification of a hybrid financial instrument adopted by the issuer, nor is the issuer bound by the classification adopted by the investor.76 This means that, an instrument can be treated as dividend in issuer’s country while being treated as interest in the investor’s country. It is less likely that the classification conflict will arise, in a cross-border situation, where the hybrids that contain only one hybrid characteristic since most countries seem to be unanimous about the classification.77 It is more likely that classification conflict will emerge when a hybrid instrument contains more than one equity characteristics.78 Such conflicts may cause the overtaxation problem when the instrument is recognized as dividend which is not tax deductible and subject to dividend withholding tax in the issuer’s state, and is treated, in the investor’s state as interest.79 On the other hand, it will lead to an undertaxation problem when the payment of interest is tax-deductible in the borrower’s jurisdiction and when the laws of the country of residence of investors classify that instrument as equity, and the payments consequently treated as dividend which are tax-exempted under exemption with participation regime.

2.3. Tax treaty classification
Classification conflicts can be solved under the treaty definition of the term dividend or interest, which in most cases, is independent of domestic tax law classification of the country of issuer or of investor. Because of an overlapping characteristic between the debt/equity borderline of hybrid securities, reading only the definition of dividend and interest from Article 10(3) and 11(3) may cause different conclusion whether an instrument will qualify under the dividend or interest definition. It should be noted that, the OECD commentary in paragraph 19 on Article 11 has provided the solution for such an overlap interpretation. According to paragraph 19, “…the term ‘interest’ as used in Article 11 does not include items of income which are dealt with under Article 10”. Therefore, as long as the income on a hybrid instrument qualifies under the dividend article, it qualifies as a dividend rather than interest for

76 77

Shelton, supra footnote 15, at 507.

Helminen, M., “Classification of Cross-Border Payments in Hybrid Instruments” (Feb ruary 2004), 58 Bulleting for International Fiscal Documentation: official organ of the Int. Fiscal Association. Amsterdam: International Bureau of Fiscal Documentation, 56-61,at 57. 78 Ibid.
79

Ibid.

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purposes of most tax treaties.80

2.3.1. Dividend definition
According to Vogel, dividend as defined in Article 10(3) of the OECD Model can be better described in as three different income from: (1) shares, “jouissance” shares or “jouuissance” rights, mining shares, or founders’ shares; or (2) other rights, not being debt-claims, participating in profits; as well as (3) other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the state of which the company making the distribution is a resident.

Paragraph 23 on Article 10 of the OECD Commentary makes clear that the definition of dividend provided by OECD Model is not exhaustive due to the great differences between the laws of OECD Member countries. Consequently, the definition merely mentions examples which are to be found in the majority of the Member countries.

From the OECD definition, it can be concluded that only income arises from ‘corporate right’ can give rise to ‘dividend’. 81 The phrase “as well as from other corporate rights” indicates that the rights mentioned in the first two parts of the definition are also corporate rights.82 The term ‘corporate rights’ is not defined in OECD Model. Thus, it is important to answer two following questions in order to achieve a right classification: (1) Should the term ‘corporate rights’ be interpreted autonomously in accordance with the rules in OECD Model or should be interpreted in accordance with the definition of dividends in the domestic laws of the source state? (2) What is the distinction between ‘corporate rights’ and ‘debt claims’?

Ibid., at 58. Helminen gave an example of The US Model Income Tax Convention that also contains the principle of giving priority to dividend treatment under Article 10 over interest treatment under Article 11. 81 Vogel K. (1997), Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD-, UN-, and US Model Conventions for the Avoidance of Double Taxation on Income and Capital, with Particular Reference to German Treaty Practice, London; Boston: Kluwer Law International, at 649. 82 Helmiinen, supra footnote 77, at 58.

80

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To answer the first question, Vogel pointed out that, it is clear that ‘corporate rights’ in the first two parts of the definition of dividends are autonomous and must be interpreted with reference only to the treaty itself. The problem lies on the third part of the definition which refers to source-state classification. Despite an existence of such reference, Vogel pointed out that, this term has to be interpreted autonomously and not in accordance with the dividend definition of domestic laws of the source state, because otherwise it would have been redundant to include this term in the third part of the dividend definition to mention expressly that remuneration subjected to the same taxation treatment as income from shares under the laws of the State of source must arise ‘from…corporate rights’.

In practice, many countries, when being in a position of residence state, tend to follow the tax treatment of source state. If the source state taxes an item of income as a dividend, the income also qualifies as a dividend under the tax treaties following the OECD Model and the residence state should accept the dividend classification.83

In order to answer the second question, Helminen observed the wording in paragraph 1 and 3 of the OECD Commentary on Article 10. According to his observation, dividend generally means the

distribution to the shareholders as a return for the use of capital that they have made available to the company, thus a debt instrument can qualify as a dividend-generating instrument if it provides the holder a comparable position to shareholder in a company. The comparable position in this regard means that the holder of such instrument must share an entrepreneurial risk corresponding to that of a regular shareholder.84

According to Paragraph 25 of the OECD Commentary on Article 10, the question whether the contributor of the loan shares the risks run by the enterprise must be determined in each individual case, as for example the following: (1) Whether or not the loan very heavily outweighs any other contribution to the enterprise’s

83 84

Helminen, supra footnote 77, at 58.

The OECD Commentary in paragraph 24 on Article 10; The UK does not adhere to paragraph 24 above. Under UK law, certain interest payments are treated as distributions, and are therefore included in the definition of dividends. See an Observation on the commentary in The OECD Commentary in paragraph 24 on the same Article.

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capital (or was taken out to replace a substantial proportion of capital which has been lost) and is substantially unmatched by redeemable assets; (2) Whether or not the creditor will share in any profits of the company;85 (3) Whether repayment of the loan is subordinated to claims of other creditors or to the payment of dividends; (4) Whether or not the level or payment of interest would depend on the profits of the company; (5) Whether or not, the loan contract contains no fixed provisions for repayment by a definite date.

Apart from sharing the risk, a holder of such instrument should also have the right to participate in profits not only from current profit but also from any possible increment in the value of company’s business that can be enjoyed after company’s liquidation.86 The limitations on the control rights of the shareholder i.e. lack of attachment of voting power to preference shares do not lead to disqualification of the instrument to be categorized as dividend.

2.3.2. Interest definition
Interest is defined in the OECD Model Article 11(3) as income from debt-claim of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures.

The definition of interest in the OECD Model, as contrary to that of dividend, is exhaustive. 87 It does not make any reference to domestic laws. The reason is that the interest definition covers all kinds of income which regarded as interest in various domestic laws. The Commentary also suggested that, in a bilateral convention, when there is income which is taxed as interest under either of their domestic laws which is not yet covered by the definition, Contracting States, may widen the formula employed to

85

According to Vogel, it is not sufficient for the risk to be restricted to the claim to receive payment, as in the case of profit-linked interest (for example, under a profit-sharing loan). On the contrary, the risk must be like that which a regular shareholder accepts which, therefore, can be as much as a loss of the funds invested. See Vogel, supra footnote 81, at 651. 86 Vogel, supra footnote 81, at 651.
87

See Paragraph 21 of the OECD Commentary on Article 11.

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include it in by making a reference to their domestic laws.

According to the above definition, it is emphasized that income arising from debt instrument, which carries a right to participate in the debtor’s profits, is also included in the definition of interest. According to paragraph 18 of the OECD Commentary on Article 11, debt-claims, bonds and debentures, which carry a right to participate in the debtor’s profits are nonetheless regarded as loans if the contract by its general character clearly evidences a loans at interest. Further, according to Paragraph 19 of the OECD Commentary on article 11, interest on participating bonds should not normally be considered as a dividend, and neither should interest on convertible bonds until such time as the bonds are actually converted into shares. The commentary goes further on that the interest on such bonds should be considered as a dividend if the loan effectively shares the risks run by the debtor company.

2.3.3. Double taxation relief
As stated above that use of the term ‘corporate right’ in OECD Model lead to an unclear definition of dividend, many actual tax treaties differ from the OECD Model in that the third part of the dividend definition (referring to the source-state classification) does not use the term ‘corporate rights’ at all.88 As a result, if an instrument is treated as dividend-generating under the domestic laws of source state, it will also be treated as such under the tax treaties.89

It is obviously seen that when the residence state of investor has to accept the classification of the source state, the classification conflict and the double taxation are immensely reduced. 90 According to Shelton, 91 where the double taxation or non-taxation problem arises as a result of different classification in the application of tax treaties that follow the definition of the OECD Model, the problem may be solved in various ways, for example:

88 89 90 91

Helminen, supra footnote 71, at 59. Ibid. Ibid. Shelton, supra footnote 15, at 517.

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(1) States can agree to include special provisions of definitions in their bilateral tax treaties;92 (2) States may agree on a certain method of double taxation relief in the treaty by referring to domestic laws. In this case, when there is a different characterization, the domestic law provisions of the residence state will determine whether the relief will come in the form of a credit or an exemption both as regards the classification of the income and as regards the computation of the actual amount of the relief to be granted.93 (3) Some countries, such as Germany, follow its own rules only as regards the computation of the actual amount of the relief but remain silent on the classification issue. As a result, the classification issue remains a matter of treaty interpretation.

92

See Article 24 paragraph 3 of the Netherlands-Sweden Treaty, the descriptive definition of interest in Article 23 paragraph 2b of the treaties between Belgium and the UK or between Germany and Canada, and the descriptive type of dividend income in Article 24 paragraph 1a of the United States-France Treaty. 93 In some countries, the domestic rules can be narrower than those contained in the treaty. As a consequence, the relief can still being granted in the case of UK and Australia, or being denied in the case of US and Canada. When the domestic rules are broader than those contained in the treaty, the broader relief is granted.

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CHAPTER 3

DEBT AND EQUITY CLASSIFICATION: UK TAX LAW CLASSIFICATION

3.1. Overview
As mention earlier in the second chapter that in order to determine the nature of an instrument, the legal form of the instrument is the first thing that has to be looked at. The UK tax legislation does not define the term debt or equity. Therefore, legal rights and obligation created by an instrument must be considered in order to identify its legal form.94 For example, the dividend is paid as a return on the capital that the shareholder made available to the company under the shareholder-company relationship.95 The right and obligation of the shareholders in the company is governed by company’s Articles of Association. 96 Basically, the company’s Articles of Association will state that the shareholder will have basic rights and obligation, for example, an entitlement to enjoy the profits of the company by the distribution of dividend or on a winding up, and an entitlement to participate and vote in the general meeting of the company.97 On the other hand, the periodic return on the use of the fund will be classified as interest payable which will be tax deductible to the issuer when an instrument that generates such return fall under the definition of loan relationship.98 ‘Loan’ is defined in FA 1996 s 103 as including ‘any advance of money’. 99 Southern explained that, there are three aspects that will constitute the loan of money: (1) a deposit or transfer of money which creates a debtor/creditor relationship; (2) the obligation of the debtor to pay interest or an interest-equivalent, though the creditor may forego his right to interest;
94

Penny, M., International Fiscal Association (2000), Cahiers de droit fiscal international/ Studies on International Fiscal Law: UK National Report on Tax Treatment of Hybrid Financial Instruments in Cross-Border Transactions, Munich: Kluwer Law International, at 647. 95 Helminen, supra footnote 77, at 58.
96 97 98 99

Penny, supra footnote 94, at 647. Ibid. FA 1996. Southern, supra footnote 13, at 80.

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(3) the promise of repayment.100

In general, legal substance, rather than the accounting treatment or underlying economic characteristics of the transaction is a determinative factor to identify the legal categorization of the instrument.101 In Chow Young Hong v Choong Fah Rubber Manufactory102, Lord Davlin observed: ‘The task of the court in such case is clear. It must first look at the nature of the transaction which the parties have agreed. If in form it is not a loan, it is not to the point to say that its object was to rise money for one of them or that the parties could have produced the same result more conveniently by borrowing and lending money.’103

However, the general principle of respecting the characterization of an instrument attributed by the parties has some exemptions.104 One exemption is in the case where (i) the arrangements are designed to achieve a different object from those expressed by the documents; (ii) there is a common intention to mislead and; (iii) the transaction envisaged by the document are not in fact carried through. 105 The doctrine of sham will apply allowing the court to discern the true nature of the instrument.106

In addition, where the legal form of an instrument is clear, the Inland Revenue can still argue in the court on the economic substance of an instrument.107 In order to understand the changing decision and the mood of the court, it is important to look at the list of cases started with Ramsay Ltd v IRC.108

Southern makes the reference to Beale, H. (1999), Chitty on Contracts Vol.2-Specific Contracts with 4th Supplement, London: Sweet & Maxwell, at paragraphs 38-221; and also the definition of deposit defined in Financial Services and Markets Act 2000, Sch 2, paragraph 22; and also the definition of deposit defined in ICTA 1988 s 481(3). 101 Southern, supra footnote 13, at 81.
102 103 104 105 106 107

100

[1961] 3 All ER 1163, at 1167. Southern, supra footnote 13, at 81. Penny, supra footnote 94, at 647. Ibid. Ibid.

Ibid. 108 [1982] AC 300. Also see the series of following cases, Craven v White [1988] STC 476 (HL); IRC v Willoughby [1997] 1 WLR 1071; [1997] 4 ALL ER 65 (HL); Countess Fitzwilliam v IRC [1993] 3 ALL ER 184, [1993] STC 502; Pigott (Inspector of Taxes) v Staines Investments Co. Ltd [1995] STC 114; Ensign Tankers (Leasing) Ltd. v Stokes (Inspector of Taxes) [1991] STC 143; CA; [1992] 2 All ER 275; IRC v McGuckian [1997] 3 ALL ER 817; [1997] STC 908 (HL (NI)); MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd. [2001] UKHL 6; [2003] 1 AC 311 (HL); Barclays Mercantile Business Finance Ltd v Mawson (Inspector of Taxes) [2004] UKHL 51; [2005] 1 AC 684; Inland Revenue v. Scottish Provident Institution, [2004] UKHL 52; [2005]

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3.2. Tax treatment of interest paid
To determine whether or not the interest paid is deductible for tax purposes, the interest-generating instrument must dealt with under the corporate debt regime contained in FA 1996. The important provision relating to the definition of such instrument is in section 81.

‘S 81(1) …a company has a loan relationship…wherever (a) the company stands (whether by reference to a security or otherwise) in the position of a creditor or debtor as respects any money debt; and (b) that debt is one arising from a transaction of the lending of money…’

‘S 81(4)…debt shall not be taken to arise from a transaction for the lending of money to the extent that it is a debt arising from rights conferred by shares in a company.’

The term ‘money debt’ from above definition shows that an instrument which does not provide for the monetary settlement but provides for the delivery of other securities such as mandatory convertible security will not be treated as a loan relationship.109

3.3. Application of integration method: Reclassification of payments
In many cases, where the instrument paying interest contains some equity characteristic, it might be reclassified under ICTA 1988 s 209 for various tax purposes. The principal method of s 209 is to deem that an element of that interest as a distribution,110 for example: (1) s 209(2)(d) provides that interest payments on securities that are convertible whether directly or indirectly into shares in the company (unless listed on The Stock Exchange) are distributions.111 (2) s 209(2)(e)(iii) provides that where the interest payment is dependent on the result of

STC 15. 109 Penny, supra footnote 94, at 649.
110 111

Ibid.

These rules do not apply if the payment is to another company within the charge to corporation tax, except to the extent that the interest exceeds a reasonable commercial return and subject to certain other exceptions. See Lee, N. (2007), Revenue Law – Principles and Practice, West Sussex: Tottel Publishing, at 1045.

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company’s business, the payment is dividend and not interest;112 (3) s 209(2)(e)(vi) provides that the securities in respect of which the interest is paid, are ‘connected with’ shares, ie a debt security is held with a share and the two have to be disposed of together, must be treated as distribution.113
(4) s 209(2)(e)(vii), (9)-(11) provides the term and reclassification of ‘equity loans’. Equity Loans

are perpetual debt instruments, an instrument that has no fixed maturity or maturity in excess of 50 years. If equity loans are held by an associated company, interest payable on such loan will constitute distribution.114

An interest-paying instrument that contains equity characteristics such as long or no maturity date, participation in profit, mandatory convertible into shares, or payment in shares, is mostly issued by the company to its shareholders. This type of instrument is called ‘quasi-equity’, an instrument that entitles the holder to an equity type return and exposes him to an equity type risk.115 Quasi-equity provides the shareholder a right to extract capital prior to a winding up and a higher priority on a winding up.116 The ‘connected party debt’, a debt owed to a shareholder or related creditor, is in general treated, for tax purposes, as disguised equity, if it has an economic characteristics as equity capital as describe in s 209. 117 Thus, interest payments of such instrument are non-deductible for the borrower, and as a dividend by the lender. In addition, interest payments can be treated as dividend for the borrower while still being taxed as interest in the hand of lender, subject to ‘corresponding adjustments’ in ICTA 1988, Sch 29AA, para 1, 6.118

In some cases, the tax treatment of an instrument is different from that of its legal form. For instance, S 477(a) ICTA 1988 provides that permanent interest bearing shares issued by a building society have the

112

Section 209(2)(e) does not apply to any part of a distribution to which s 209(2)(d) applies. Southern, supra footnote 13, at 117. 113 Ibid., at118.
114 115 116 117 118

Holding companies chargeable to UK corporation tax are not affected by this provision. See ICTA 1988 s 212. Southern, supra footnote 13, at 13. Ibid. Ibid. Ibid.

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legal form and description of equity with a return described as interest.119

3.4. Application of bifurcation method
According to HMRC Corporate Finance Manual, 120 the method of bifurcation is used by the International Accounting Standards and revised UK GAAP as a tool to treat certain financial assets and liabilities as if they were two or more sets of rights bundled together. An instrument that will be bifurcated normally has the features that constitute a contingent return as found in a derivative contract.121 Convertible bonds, exchangeable bonds and bonds linked to the value of a chargeable asset come within this description.122 IAS and revised UK GAAP require both holder and issuer to bifurcate the security into two components: (1) The underlying ‘host contract’, a financial asset or liability which has the characteristics of a simple (though discounted) loan, and; (2) An ‘embedded derivative’,123 which will be: (a) In the case of a convertible/exchangeable, an option to convert/exchange the security for shares, or (b) In the case of an asset-linked security, a ‘contract for differences’ under which the amount payable on redemption will depend on the percentage rise or fall in the value of the specified assets over the life of the security.124

119 120

Penny, supra footnote 94, at 647.

HMRC Corporate Finance Manual, CFM16625 - Taxing Loan Relationships: “Hybrid” Securities: Accounting Treatment of Bifurcation,<http://www.hmrc.gov.uk/manuals/cfmmanual/CFM16625.htm>, accessed 1 August 2008. 121 Ibid.
122 123

Ibid.

An embedded derivative is only required to be bifurcated from host contract and accounted for at fair value where the following three criteria are met: (1) The embedded derivative’s economic characteristics and risks are not closely related to those of the host contract; (the term ‘closely related’ is defined in IAS 39 AG30 and AG33) (2) A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative; and (3) The entire contract is not accounted for ‘at fair value through profit and loss’. 124 HMRC Corporate Finance Manual, supra footnote 120.

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3.5. UK thin capitalisation classification
Before 1 April 2004, the UK disallowed deduction for interest and reclassified such interest as dividends subject solely to the provision of ICTA 1988 s 209. This provision applied to treat the excessive amount as interest as a distribution where: (1) Either the borrower is a 5% subsidiary of the lender or both are 75% subsidiaries of a third company; and (2) The whole or any part of the interest paid is greater in amount than would have been paid between unconnected parties.125

From 1 April 2004, the UK thin capitalisation rules have been included into the transfer pricing regime, thus, arm’s length rates and gearing ratio must be applies to loans made between companies where one controls the other, or the same person can control both (ICTA 1988 s 770A and Sch 28AA).126

3.6. Accounting classification
In order to determine what is a loan relationship, legal definition has to be considered. Accounting standards are not relevant in determining whether an instrument is a loan relationship. 127 Preference shares provide an example where instruments are treated as liabilities for accounting purposes but remain shares for tax purposes.

IAS 32 and IAS 39, which have been later imported into UK GAAP by FRS 25 and FRS 26 respectively, are the two main standards that provide the rules governing accounting for financial instruments. Southern pointed out the scope of both accounting standards as following: ‘…IAS 32 (Financial Instruments: Disclosure and Presentation) specified ‘how’ financial instruments should be classified in financial statement while IAS 39 (Financial Instruments: Recognition and Measurement) specified ‘when’ a financial instrument is to be recognized on the balance sheet and at what amount and also when to remove a financial instrument from the balance

125 126 127

Lee, supra footnote 111, at 1027. Ibid. Southern, supra footnote 13, at 73.

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sheet, and what to do with gains and losses.’128

Paragraph 15 of IAS 32 applies a substance over form model to debt/equity classification.129 The main test is whether the payment, whether in the form of cash or other financial assets, is solely at the discretion of the issuer. If not being so, the issuer has a contractual obligation to make a payment and instrument that generates such a payment is classified as liability. An example can be found in the case of preference shares. A preference share will be classified as a financial liability if it has the following two characteristics:
(1) it is mandatorily redeemable on a certain date and the issuing company has such a contractual

obligation; and
(2) if the share is non-redeemable, but the company has a contractual obligation to pay a dividend.

Further, under IAS 32, paragraph 35 provides the treatment of the coupon of an instrument. It specified that the coupon follows the treatment of the principal, so if the preference share is classified as debt, its coupon will be shown as interest while the coupon on an instrument that is classified as equity will be shown as distribution.130

3.7. Consequences of classification under integration method 3.7.1. Consequences of classification to an issuer
UK tax legislation has been using a number of criteria under ICTA 1988 s 209 to determine the debt/equity boundary. It can be concluded that the UK has been using an integration method to reclassify hybrid securities that have the equity characteristics such as participating loan, subordinated debt, perpetual debt, and equity loans. The consequences of such classification is that the payment of such instrument will be treated differently as either interest or dividend which would constitute different tax treatment to the issuer in the following matters: (1) The deductibility of the periodic payment;
128

Southern, D., ‘Course Material on Embedded Derivatives’, UK Business Taxation 2007/2008, Queen Mary, University of London. 129 Southern, supra footnote 13, at 56.
130

Ibid.

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(2) Timing of deduction; (3) Grouping; and (4) The release/redemption of the debt.

3.7.1.1. Deductibility of the periodic payment
As stated above that an instrument that will generate the tax deductible payment must have characteristics in accordance with the term of a loan relationship under FA 1996.131

3.7.1.2. Timing of deduction
When an instrument is classified as a loan relationship, periodic return whether in a form of interest, discount, or premium will be deductible by the issuer on either an ‘amortised cost basis’ or ‘fair value accounting basis’ 132 depending on the accounting method adopted by the issuer in respect of that instrument, provided the method used accords with an authorized method of accounting defined by IAS 39 or FRS 26.133

In some special cases such as where the lender and borrower are connected, an authorized accruals basis must be adopted by both parties.134

3.7.1.3. Grouping
The issue of a hybrid instrument can have an effect o the UK tax grouping of the issuer.135 ICTA 1988 s 413(7)-(10) provides that for the group relief to be available, three of the following criteria need to be met. (1) one company (‘the parent company’) must own, directly or indirectly, 75 per cent of the

131

As the details of the rules of FA 1996 is beyond the scope of this dissertation, please see Southern’s book for the detailed explanation of FA 1996. Southern explained that ‘amortised cost basis’ is very close to accruals of historic cost…while ‘fair values are current market values, ie the amount a company would receive for an assignment of the asset or would have to pay to be relieved of a liability. Southern, supra footnote 13, at 29. 132 The terms ‘amortised cost basis’ and ‘fair value basis’ of accounting are defined in FA 1996 s 103(1).
133 134 135

Penny, supra footnote 94, at 649. Ibid. Ibid., at 653.

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‘ordinary share capital’ of the other company (‘the subsidiary’) (2) the parent company must be beneficially entitled to at least 75 per cent of profits available for distribution to ‘equity holders’ of the subsidiary; and (3) the parent company must be beneficially entitled to at least 75 per cent of the assets of the subsidiary available for distribution to its ‘equity holders’ on a winding up.

The term ‘ordinary share capital’ means that the fixed rate preference shares are excluded.136 The term ‘equity holders’ means that the holder of a debt security which does not represent a ‘normal commercial loan’ will be included.137 As a result, a holder of debt instrument that is recharacterised under s 209 is deemed an ‘equity holder’.138

3.7.1.4. Release of the debt
Where the borrower and the lender are connected parties, under FA 1996, sch 9, paras 5(3), 6(3), the borrower will not be chargeable to tax in respect of the amount released but conversely, the lender will not be entitled to bad debt relief.139 The reason is that the release of debt of a related debtor contains two elements: (1) a disguised investment by the creditor in its shareholding; and (2) a disguised transfer of losses from debtor to creditor.140

3.7.2. Consequences of classification to an investor
In the case of debt instrument, the tax treatment and timing issue in an aspect of the investor is similar to that of issuer. To clarify, the entire return arising from an instrument that is classified as a loan relationship will be charged to tax as income either on an amortized cost or fair value depending on the accounting method adopted by the investor.
136

ICTA 1988 s 832; Ibid., at 653; See also Revenue & Customs Brief 54/07, Meaning of Ordinary Share Capital,<http://www.hmrc.gov.uk/briefs/company-tax/brief5407.htm>, accessed 7 August 2008. 137 The term ‘normal commercial loan’ is defined in ICTA 1988, Sch18, para 1(5); Penny, supra footnote 94, at 653; See also Capital Gains Manual, CG53742 - Corporate bond: definition: normal commercial loan, < http://www.hmrc.gov.uk/manuals/cg3manual/CG53742.htm>, accessed 10 August 2008. 138 Penny, supra footnote 94, at 653.
139 140

Ibid., at 653-654. Southern, supra footnote 13, at 13.

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Again, in the case of connected parties, an authorized accruals basis must be adopted by both parties.

In the case of an instrument recharacterised by ICTA 1988 s 209, the payment of the recharacterised interest will be tax exempt in the hands of a UK corporate investor when the investor does not hold the shares in the course of its trade (ICTA 1988 s 95).141

Regarding the tax liability on the capital value of the share, subject to the same requirement, if the investor does not hold the shares in the course of its trade, any movement in the capital value of the shares will be taxed or relieved on disposal of shares under the capital gains tax regime.142

3.8. Consequences of classification under bifurcation method: Convertible bonds
Southern pointed out that, an investor who holds a convertible bond has in substance two instruments; (i) a debt instrument which offers him the obligation to pay back his principal and may, in addition, provides him the periodic payment, and (ii) a share option which provides him the right to acquire a certain number of shares in the issuer at a fixed price on a future fixed date. Thus, in the aspect of investor, tax relief or tax liability occurred when (i) there is a fluctuation in the principal value of convertible bond, and (ii) any interest received on the bond. 143

FA 1996 Section 92 provides that a rise in the principal value of convertibles will be subject to tax under the UK’s capital gains tax regime. The consequence of this is that the tax will be charged on the disposal of such an instrument.144

Regarding the timing of deduction, the interest received is taxed as income under the loan relationship (as explained in Example A). In the case of derivative contract, as the tax rules governing derivative contracts closely follow the accounting treatment, under IAS 39, FRS 26, all derivative contracts must be carried on the balance sheet at fair value and any subsequent movements must be taken through the
141 142 143 144

Penny, supra footnote 94, at 654. Ibid., at 655. Southern, supra footnote 117 Penny, supra footnote 94, at 650.

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income statement.145

On the other hand, an issuer has an obligation to pay the redemption price and contingent equity. Interest payable, arising from the host contract, will be treated as deductible under the loan relationship as same as treated by the investor. Also, the fluctuations in the principal value of the bond will be treated under the loan relationship.146

As regard to the conversion option, Southern explained that, it will be accounted for as an equity instrument of the issuer as opposed to a derivative financial instrument and is therefore not subject to the requirement to account for the embedded derivative at fair value. The amount allocated to equity on issue of the bond is not subsequently revalued at all for accounting purposes.147

Example A148 D Ltd can borrow money at 8%. Its shares trade at 45. It issues a two-year bond for £1,000, paying interest at 1% annually and convertible at the end of two years into 20 D Ltd shares. Solution 1. The fair value of cash flows on a host contract can be found by discounting the principal at 8% market interest rate during the period of two years by using the ‘Present Value Interest Factor of $1 per Period at i% for N Periods’ table. According to the table, the fair value of cash flows on the host contract is £857 (0.857 x 1,000). 2. Thus, the equity component is the difference between the issue price and the fair value of the host contract which is £143. 3. At the end of day 1, the Journal of the issuer will be: Journal Entries Cash Liabilities Dr. 1,000 857 Cr.

145 146 147 148

Southern, supra footnote 13, at 57-58. Penny, supra footnote 94, at 650. Southern, supra footnote 117. Ibid.

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Equity instrument

143

For the investor, the journal entry will be: Journal Entries Debt Asset Other Asset (Derivative contract) Cash Dr. 857 143 1,000 Cr.

4. The bond is treated as bifurcated into a discounted bond issued at £857 and accreting to £1,000 over two years. In order to calculate the amount of interest payable in the hand of issuer and interest received in the hand of investor, an effective rate of interest must be found using the formula Where, i = (A/P)
1/n

-1

i = implied rate of interest A = amount payable on maturity

P = principal n = term 5. From the above formula, the effective interest rate is 8%. 6. At the end of year one, the interest payable or received is equal 8% of £857 which is about £69. 7. The amount of £69 will be treated as interest expense in profit and loss account of an issuer and as an income in the profit and loss account of an investor.

3.9. Application of withholding tax
UK dividends are not subject to UK withholding tax.149 However, the recipients are imputed with a credit of 1/9 of the dividends which is not reclaimable.150 As a consequence, the amount of dividends paid to an investor carry a tax credit of 1/9. Under the provision of some Double Taxation Agreements, the foreign shareholders will receive the

149 150

ITA 2007 ss 8,9,13-15 and 19, ITTOIA ss 382-385 Sinclair, W. and Lipkin, E. (2007), St James's Place Tax Guide 2007-2008, Hampshire: Palgrave Macmillan,

at 52.

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repayment of the tax credit of 1/9. The refund of tax credit is subject to two requirements: (1) the foreign investor has at least 10 per cent voting interest in the UK issuer; and (2) the payment is not only a distribution under UK law but also a dividend for the purposes of the applicable tax treaty.151

Regarding interest payment, withholding tax is only applied to yearly interest of money. Yearly interest is interest calculated by reference to a period of a year or more, whereas, short interest is calculated by reference to a shorter period. 152 In a cross-border situation, when an interest is paid to a resident of a country that has the Double Taxation Agreement with the UK, the UK withholding tax rate can be limited or the interest can be taxable only in the country of residence of the payee.153 Many of the UK’s tax treaties exempt the non-resident investor fully or partly from withholding tax on interest.154 In most of these treaties, the definition of interest is the income derived from a ‘debt claim’.155 An exemption occurred when the withholding tax is levied on the deemed interest payments where there is no underlying debt claim. Consequently, the interest article of the treaty may be inapplicable.156 However, the withholding tax can still be avoided under the business profits or other income article.157

151 152 153 154 155 156 157

Penny, supra footnote 94, at 659. ICTA 1988 s 349(2); Southern, supra footnote 13, at 118. Ibid., at 123. Penny, supra footnote 94, at 659. Ibid. Ibid. Ibid.

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CONCLUSION

It is clear from the discussion in Chapter 1 and 2 that there is no sound theoretical basis for distinguishing debt and equity. Basically, instruments that have the economically equivalent cash flows should receive the equivalent tax treatment in order to reduce tax avoidance opportunity. This is extremely hard to achieve. The main reason is that there are several factors the company raising funds needs to consider, for example, regulatory restriction, credit rating, accounting standard and tax law. In order to classify an instrument whether it is a debt or equity, there is no shared principle among credit rating, accounting and taxation classification. To clarify, according to Pinedo, ratings agency classification and accounting classification focus on the effect of the security on the issuer’s capital structure and cash flows while tax classification more focuses on the rights of the holders of the hybrid security as compared to the rights of the issuer’s other security holders. As a result, economically equivalent cash flow can be equivalently treated for the credit rating proposes but may be taxed differently because of the different components in a transaction. This obviously, creates opportunities for tax avoidance and tax arbitrage. The legislative and judicial branch has been trying to find the way to tackle this. The revenue authorities of many countries release the set of rules to tax some innovative financial instruments according to their economic characteristics instead of their legal forms. The two method of distinguishing debt and equity, integration and bifurcation method, have been proposed. Under the former method, terms of the instrument and all facts and circumstances are used to identify whether an instrument has more debt or equity characteristic in order to categorize it as wholly debt or wholly equity. Although the objection of this method is based on the fact that this method cannot deal with the sophisticated financial instruments, most of the countries still apply this method instead of bifurcating instruments into smaller components and tax them separately.

The problem is even greater in cross-border situations where the instrument can be treated differently for tax purposes, and, in many cases, the problem of tax treaties interpretation of the term ‘interest’ and ‘dividend’ occurs.

Therefore, from an example of UK tax treatment on hybrid securities, in order to create a tax-effective

43

instrument, in the case of domestic payments, the issuer and the investor of an instrument has to consider these following questions: (1) What is the legal form of the instrument? (2) Is it likely that the legal form of an instrument would be challenged and recharacterised under the tax avoidance scheme? (3) Does an instrument contain some characteristics that will trigger the reclassification of the payment as something else? And what if an instrument is issued to the shareholders? (4) When the payment of an instrument is reclassified under one provision for some certain purposes such as, tax deductibility purposes, will the result of that reclassification also be used for other tax purposes such as thin capitalisation or grouping structure for group relief?

In the case of cross-border situations, some more factors need to be considered; (1) How is the instrument classified under the tax treaties? (2) In the case that the payment is reclassified as the dividend, would it still be considered as dividend under the definition of the tax treaties? (3) Is there any obligation on the part of the investor/issuer to complete a tax return which classifies a hybrid instrument in the same manner as the issuer/investor?

In my opinion, the increasing use and the innovation of hybrid securities should not be looked at as a way to create a tax avoidance opportunity. Looking at the bright side, hybrid securities provides corporations and especially multinational enterprises a way to minimize the expense which means that it helps the business to maximize the profit. The revenue authority should not only think about the way to maximize the amount of revenue collected but also the taxation that will provide a certainty to the tax payers which would, as a result, help boost the competitiveness of local enterprises and promote the stability of financial markets.

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Websites Answers.com, ‘Convertible Bond’ (Investment dictionary), < http://www.answers.com/ topic/convertible-bond>, accessed 20 July 2008. Answer.com, ‘Hybrid Security’ (Investment dictionary), <http://www.answers.com/topic/ hybrid-security?cat=biz-fin>, accessed 14 August 2008. Borsa Italiana, ‘What are hybrid bonds – Part One’, < http://www.borsaitaliana.it/ documenti/rubriche/sottolalente/bondibridiparteprima.en.htm>, accessed 14 August 2008. Gillian Ridgway, ‘Halifax Group plc Innovative Tier 1 securities’ (Practical Law Company Report 2004), <http://finance.practicallaw.com/9-101-1319>, accessed 14 August 2008. Western Asset, ‘Hybrid Capital Securities’ (Commentary 2004), <http://www.weste rnasset.com/us/en/commentary/hybrid_capital_200703.cfm>, accessed 14 August 2008.

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MacNiven (Inspector of Taxes) v Westmoreland Investments Ltd. [2001] UKHL 6; [2003] 1 AC 311 (HL)

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Pigott (Inspector of Taxes) v Staines Investments Co. Ltd [1995] STC 114 Welsh Development Agency v Export Finance Co Ltd [1992] BCLC 148 WT Ramsay Ltd v Inland Revenue Commissioners [1982] AC 300; [1981] 2 WLR 449 STC 153 (HL)

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PLAGIARISM
Candidates who write an essay as part of the LLM examination will be required, on submission of the essay, to sign the following statement and attach it to the essay (copies of the statement will be available in the Law Schools):

“You are reminded that all work submitted as part of the requirements for any examination of the University of London must be expressed in your own words and incorporate your own ideas and judgements. Plagiarism, - that is, the presentation of another person’s thoughts or words as though they were your own – must be avoided, with particular care in course-work and essays and reports written in your own time. Direct quotations from the published or unpublished work of another must always be clearly identified as such by being placed inside quotation marks, and a full reference to their source must be provided in the proper form. Remember that a series of short quotations from several different sources, if not clearly identified as such, constitutes plagiarism just as much as does a single unacknowledged long quotation from a single source. Equally, if you summarise another person’s ideas or judgements, you must refer to that person in your text, and include the work referred to in your bibliography. Failure to observe these rules may result in an allegation of cheating.

My supervisor has shown me the above statement concerning plagiarism and in accordance with it I submit this essay as my own work.

Signed: ……………………………………………………………..”

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