Hybrid instrument advantages in cross-border investment Instruments may be treated as debt for foreign income tax purposes but as equity or U.S. tax purposes. Other instruments exist that may be treated as debt for U.S. tax purposes and as equity for foreign tax purposes. These instruments are often used within a multinational group to achieve cross-border tax arbitrage, to accomplish foreign or U.S. tax base erosion, or to engage in foreign tax credit planning. The ability to use hybrid instruments to engage in foreign tax credit planning was significantly curtailed with the enactment of Code section 909. Pub. L. No. 111-226, sec. 211. Prior to enactment of section 909, certain hybrid instruments treated as debt for foreign tax purposes and as equity for U.S. tax purposes were used to help facilitate certain “foreign tax credit splitter” transactions where creditable foreign taxes were separated from the underlying foreign earnings and profits.
Such instruments may also be used by investors (e.g., investment funds) making cross border investments. One such example is a Convertible Preferred Equity Certificate (“CPEC”). A CPEC is a hybrid financing instrument designed to be regarded as debt of a Luxembourg issuer from a Luxembourg tax perspective, Although the IRS will typically not issue a private letter ruling, it is not uncommon for issuers of CPECs to obtain a ruling from Luxembourg tax authorities confirming the treatment of CPECs as debt, but equity from a U.S. tax perspective. Profit participating loans are another example of a hybrid instrument that may be treated as debt in Luxembourg and certain other foreign jurisdictions while being treated as equity from a U.S. tax perspective.
Typical features of the CPEC include a 49-year term; a fixed annual interest rate computed based on the “arm’s-length” principle, taking into consideration their conversion feature; convertibility into shares of the issuer at a fixed ratio established upon the issuance of the CPECs; an ability to be redeemed at fair market value under certain conditions; transferability by the holder only with the simultaneous transfer of an equivalent portion of the holder’s shares of the issuer; subordination to other debt; and no voting power.
Because CPECs are treated as debt for Luxembourg tax purposes, interest expense may be imputed on CPECs resulting in Luxembourg tax deductions. In addition, interest paid on CPECs is generally exempt from Luxembourg withholding tax. From a U.S. perspective, assuming the holder is treated as owning equity, interest imputed on a CPEC does not result in corresponding imputed interest income in the United States. Holders typically owe U.S. tax on dividend income only when declared and paid. In addition, CPECs are convertible into common shares and under certain circumstances are redeemable. Because conversion or redemption is typically carried out at the fair market value of the shares at the time of the conversion or redemption, holders are able to extract appreciation in the issuer in a tax efficient manner. From a Luxembourg perspective, a conversion is not a dividend subject to withholding, and from a United States holder’s perspective, the exchange may qualify for a preferential rate of tax as qualified dividend income or the sale or exchange of a capital asset. Since CPECs are also treated as equity in certain foreign jurisdictions, CPECs may also be used to facilitate cross-border arbitrage between Luxembourg and other foreign jurisdictions.