Insight Center: Publications

Strategies and Hybrid Instruments: A Practitioner's Perspective

Author: Steven D. Bortnick

This article first appeared in the June 15, 2007 (Vol. 11, No. 11) edition of Practical U.S./International Tax Strategies. It is reprinted here with permission by WorldTrade Executive.


Hybrid financial instruments are being increasingly used in cross border transactions. Practical Tax Strategies talked with Pepper Hamilton’s Steve Bortnick to find out why. Bortnick has been called upon to structure cross-border acquisitions and dispositions, tax-free spin-offs, recapitalizations, and reorganizations. He has written and lectured extensively on the tax aspects of cross-border investing.

Strategies: Please define a hybrid instrument.

Bortnick: A hybrid financial instrument is an instrument that is classified as debt in the country in which the issuer was formed and as equity in the United States.

Strategies: What are the strategic reasons for designing an issuance that uses a hybrid instrument?

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

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

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

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

Strategies: In the media company transaction you just mentioned, how did you structure the instrument to make sure it qualified as equity in the U.S.?

Bortnick: The subordination aspect and high debt-to-equity ratio (if the hybrid were treated as debt in the U.S.) as well as certain other factors, made us comfortable that these notes would fit under the definitions of equity in the U.S.

Meeting the Requirements of the Foreign Jurisdiction

Strategies: How do you know the kind of terms the hybrid instrument will need to be treated as debt in a foreign jurisdiction?

Bortnick: One needs to work carefully with local counsel to tailor the instrument to local requirements. We work with local counsel to draft the instrument in a way that is designed to meet the particular criteria in the foreign country to qualify as debt.

Advance Rulings

Strategies: Can you get an advance ruling from tax authorities in the foreign country, so that you know ahead of time how the instrument will be treated?

Bortnick: In some countries, yes. For example, we have worked on deals where the client has received rulings in Luxembourg for issuance of hybrid instruments. Counsel can meet informally with the tax inspector and discuss the transaction and then counsel can make changes required by the tax inspector, and subsequently obtain a binding written ruling. This is a much more expedited process than in the U.S., for example, where it takes three to six months to get a ruling.

Term, Debt-to-Equity Ratio

Strategies: What kind of notes have you seen the Luxembourg authorities rule on? What was the term?

Bortnick: The typical hybrid instrument in Luxembourg is the Preferred Equity Certificate (PEC). In a deal I did several years ago, the PECs were issued with a 150-year term. That, obviously, is a very long term, and gave us comfort that the more recent transactions, tax inspectors have limited the term to 49 years. I am hearing from some people that the term is being further reduced, that today it may be difficult to get a 49-year term approved. People are still comfortable that 49 years is a good, long term. It’s still longer than typical bonds. But the term is only one of the factors that is considered for U.S. tax preparers. Other important factors include the debt-to-equity ratio. In the PEC context, it would be common to finance the company with 1 percent equity and 99 percent PECs. That is a high debt-to-equity ratio and does not even take into account that PECs typically are structurally and contractually subordinated to the bank debt that would be in the company under the Luxembourg company.

Dealing with Delays in Advance Rulings

Strategies: Is the situation in Luxembourg, where lawyers can get a written ruling prior to the issuance of hybrid instruments, unusual?

Bortnick: There are other countries where one can get an advance ruling, but in most countries it will take more time than in Luxembourg. And not many deals will wait for the bureaucratic hurdles to be cleared. So what happens is that the instrument will be issued before the authorities deliver the ruling. Where there are delays in getting an advance ruling, the instrument will be issued based on advice of counsel rather than a ruling.

Strategies: Could you describe the typical procedure that is involved for counsel to structure the hybrid instrument?

Bortnick: There is much going back and forth between the local country and the U.S. One also wants to make certain that the accountants are on board. There is also the question of which side bears the most risk. If the instrument is a hybrid and the investor/buyer is a partnership with mostly tax-exempt investors, then there is more concern that the instrument look like debt locally than that it qualify as equity in the United States. Sometimes, however, a balance cannot be accomplished and other planning techniques (such as the use of hybrid entities) must be considered.

Strategies: Are countries aligning their tax provisions so as to make use of hybrids more difficult? In other words, are countries conforming their tax rules to come to common standards of treatment?

Bortnick: I have seen some countries change the rules after large deals took place that they did not like. In the U.S., for example, the IRS can make a particular type of transaction a listed transaction. Once a type of transaction is listed, that pretty much means that the deal is no longer viable.

Strategies: Has increased vigilance on the part of the tax authorities reduced the appetite for hybrid instruments?

Bortnick: Not really. Hybrid instruments are just tools to accomplish a goal. If they are not available in a certain country, another tool may be available. Each person’s appetite for these types of instruments can differ. Moreover, different tools can be combined. For example, if a practitioner is not comfortable with PECs, a Cayman partnership can be added above the Luxembourg corporation. An election would be made to treat the Luxembourg entity as disregarded and the PECs would be ignored for United States tax purposes.

Steven D. Bortnick

This article is informational only, and should not be construed as legal advice or legal opinion on specific facts.