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By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
The related-party debt versus equity question continues to be a very hot topic globally. I have written on various aspects in a number of prior commentaries, including my most recent commentary which discussed U.S. court cases on the debt-equity issue, including the recent decisions in PepsiCo and Scottish Power. Those cases, both decided favorably for the taxpayer, involved hybrid debt arrangements where the U.S. treatment of the financing transaction was inconsistent with the treatment in the foreign counterparty's country. Such inconsistent treatment and the corresponding potential for so called "double non-taxation" is a focus area for many governments and one of the six key pressure areas identified in the February 2013 report of the Organisation for Economic Co-operation and Development (OECD) on Base Erosion and Profit Shifting (BEPS).
I look forward to seeing exactly how the OECD will attempt to define and then address the issue of hybrid treatment, which is a natural consequence of countries having different tax systems. I see it as a very difficult issue to deal with on a comprehensive global basis. (Of course, I have to admit that I come at this issue with the view that double taxation is a far worse consequence than double non-taxation2 so maybe I am not creative enough about potential solutions in that direction.) The typical fact pattern that creates concern apparently is where an investee company in Country 1 deducts interest expense, but the investor company in Country 2 pays no or little tax on the interest income. This could arise for several reasons, including different tax characterizations in the two countries of the funding instrument (hybrid debt), different classifications of the borrowing or lending entity (hybrid entity), the existence of a group financing company that is subject to a lower tax rate, the existence of tax losses or other attributes in the lending entity, etc. It seems to me these are all circumstances that are the normal effects of a world with different national tax rates and statutory rules and corporate entities in global groups with different functions and attributes.
Given the multitude of reasons why there could be a potential mismatch resulting in a tax benefit to the "borrower" that is greater than the tax cost to the "lender," it is hard to see the best way to construct an anti-avoidance principle to limit such a result, assuming one thought it was appropriate to do so in the first place. One could design a tax regime to be adopted for investee countries that limits deductions for payments on debt that is treated as equity in the recipient's country, something which Denmark did several years ago. However, basing the domestic tax treatment in one country on the tax treatment of a transaction in another country is an unusual step for legislators to take. And indeed some countries for policy reasons adopt their own form of hybrid treatment - note both Belgium and Brazil as examples where the local statute explicitly provides for deductions for "interest on net equity," which is quite the opposite of the Danish example. Alternatively, the investee country could limit deductions in situations where the investor country lender pays less than a prescribed effective rate of tax on the income from the transaction, as the Netherlands does in certain situations. Dutch tax law provides that a minimum effective tax rate of 10% must be paid by the lender in order for payments on related-party debt funding a share acquisition to be deductible. This Dutch rule is not limited to the hybrid context. However, there is the potential for huge complexity in determining what the marginal effective tax rate is with respect to the finance income in question (how to deal with allocation of expenses, group relief/consolidation, loss carryovers, foreign tax credits, etc.) and this approach has not been picked up by other jurisdictions for broader application. In any event, as I have pointed out in prior commentaries, there are already a myriad of qualification and anti-abuse rules that have been adopted by investee countries to limit interest deductions for payments to foreign lenders, including thin capitalization rules, the U.S. §163(j) rules and equivalents, anti-debt pushdown/allowable purpose provisions, etc. So it is questionable to me that a new standard focused on limiting any double non-taxation potential would be considered necessary as either an additional or an alternative limitation.
An alternative approach that the OECD could pursue could be to suggest that the investor country impose tax on financing income anytime the investee country allows a corresponding tax deduction. So, under this approach, the investor country would not grant its participation exemption, or its deemed-paid foreign tax credits in the case of those few (but near to my heart) countries that still have worldwide tax systems, for amounts it otherwise sees as dividends in situations involving a hybrid instrument that generates a local tax deduction for such amounts. A number of countries have a similar rule in their dividend exemption provisions already, e.g., Denmark (again) and the United Kingdom. However, such an approach would not necessarily cover financing income earned in low-tax finance companies or income on loans between controlled foreign corporations (CFCs). Like the U.S. CFC look-through rules, many countries' CFC rules do not seek to tax foreign-to-foreign financing income. For the OECD to recommend that the investor country tax regime should ensure that otherwise low- or no-tax financing income that is deductible by investee subs is always taxed in the investor country (or the investor's parent's country) would be a huge substantive and policy change for countries to buy into.
But this has all been a frolic and detour as my main impetus for writing this commentary actually was not the OECD BEPS project at all, but rather a recent Court of Appeals tax case in New Zealand - the Alesco case. That case deals with a hybrid instrument between Australia (investor country) and New Zealand (investee country) and provides a cautionary tale about how countries might unilaterally deal with the issue of double non-taxation.
In this case, the Alesco New Zealand subsidiary was making a significant third-party acquisition and needed funding from its Australian parent. On advice of a Big 4 firm (not E&Y but seemingly good advice nonetheless), it structured the funding as a zero coupon optional convertible note (OCN). The OCN was repayable in a fixed number of shares at the option of the holder or was repayable in cash at the original issue price. Under New Zealand tax rules, which follow IFRS accounting rules, the issue consideration was bifurcated into two components - the value on date of issue of a zero coupon discount bond and the value of an option to acquire shares. The zero coupon discount was amortized as interest expense. As one could imagine, the Australian tax treatment of the OCN was not symmetrical -- the OCN was treated wholly as equity and there was no deemed interest income element that was subject to tax in Australia.
The New Zealand tax authorities obviously were offended by the resulting one-sided deduction claimed by Alesco New Zealand. Perhaps adding insult to injury, the amortized interest expense was not even subject to regular interest withholding tax, which would have been the case for a straight loan. And to top it all off (from the perspective of the tax authorities), the OCN structure was marketed as a "product" - referred to as Hinz, which stands for Hybrid Instruments in New Zealand - and the Alesco case was the front runner for other potential cases involving numerous other taxpayers that also implemented the structure. (Reminder to self - short, cute-sounding acronyms for tax planning ideas are never a good idea.)
Despite the aspects of the structure that were disturbing to the New Zealand tax authorities, it seems to me that Alesco had a lot in its favor going into its courtroom battle. The tax authorities had accepted that there was a legitimate business purpose in raising funds for the third-party acquisition. They also had accepted that the New Zealand financial arrangement rules regarding the OCN were correctly applied from a technical standpoint and that the result was within the intended scope of those provisions. I would further note that the corporate tax rates in New Zealand and Australia at the time were 33% and 30%, respectively, and that therefore it seems reasonable to conclude that, absent the use of a hybrid instrument OCN, a straight loan from the Australian parent to Alesco New Zealand, which also would have generated an interest deduction in New Zealand, would have been the likely preferred tax and treasury funding alternative - a point that was made by Alesco counsel.
Despite all of these seemingly taxpayer-favorable points, the Court of Appeals affirmed the High Court decision in favor of the tax authorities. The court's holding essentially dismissed the overall commercial context of the third-party acquisition and focused just on the use of the OCN instrument. It apparently considered the use of this convertible instrument in a cross-border, related-party context to be artificial and did not consider the convertible option to have economic value because Alesco New Zealand was already 100%-owned by the lender, Alesco Australia. The court therefore considered the tax result to be "outside the intent of Parliament" in enacting the financial arrangement rules and thus a tax avoidance transaction. That seems pretty harsh to me. New Zealand is one of my favorite countries to visit (still). But it's a pretty small place with a small population and it is quite dependent on foreign investment. I would expect Parliament to be cognizant that there would be cross-border aspects of any tax provisions it enacts and non-symmetrical treatment of cross-border or related-party ownership of financing instruments would have been relatively easy for Parliament to address in legislation should they have chosen to do so. But what do I know - I don't even recognize double non-taxation as really double anything. It also seems to me that despite the 100% share ownership at the time of issue of the OCNs, a note that is convertible into a fixed number of shares has economic significance based on the per share value of the conversion, combined with the fact that such 100% ownership of the currently outstanding shares is not assured forever or even just throughout the term of the loan.
Perhaps more disturbing was the court's unwillingness to consider whether there would have been a tax savings in New Zealand had the OCN financing alternative not been selected. Testimony was given by the Alesco finance director that, absent using the OCN, either interest bearing or zero coupon debt would have been used and that the OCN was chosen primarily due to the "non-normative" tax treatment in Australia which produced a tax benefit to the lender (perhaps a worrying statement from the Australian side?). The court dismissed this assertion as speculation and in any event concluded it did not really matter. What mattered is that there was a tax deduction claimed on the OCN in New Zealand which was unintended by Parliament, and as such this constituted a tax avoidance plan such that the interest deduction should be disallowed.
So what should one conclude from this case? First, it seems that the New Zealand courts are somewhat inclined toward sympathy to the tax authorities. Second, the use of marketed, acronymed, cross-border hybrids may incite the ire of tax authorities in New Zealand. Third, it's likely not a comfortable defense in New Zealand that "it was done for tax purposes in the other country."
Personally I don't believe it is good global tax policy to broadly rely on the courts to discern the "intent of Parliament" with respect to tax legislation. This leaves multinationals with a trap-for-the-unwary problem. In the Alesco case was the offensive aspect the fact that the unknowing Parliament did not intend the use of the OCNs cross-border with an investor that had inconsistent tax treatment? Or was it the ownership of the OCN by a related party? Or was it the combination of the two? Different courts could discern different "intents," which has the effect of rendering the capital markets less certain and reliable for various investors and which may not have been Parliament's intent either.
Coming back to the OECD BEPS project, perhaps the focus there on hybrids is a good thing. Whatever abuse is perceived in inconsistent cross-border treatment is better dealt with in specific national legislation, as was done by Denmark as mentioned above. In such case, the intent of Parliament can be made clear. The results to multinationals and the impact on capital markets are both clear. Traps for the unwary and related uncertainty are much less likely. Of course, as I pointed out at the outset, guidelines for legislative action in this area will be difficult to craft given the complexity of the issue and of the global landscape with respect to taxing financial transactions. I remain hopeful that any recommendations of the OECD will not overly exacerbate the risks of double taxation in the zeal to reduce instances of double non-taxation, which, given all of the limits on financing deductions, etc., already are quite limited. But whatever the recommendations, I am hopeful that the "intent" of the OECD will be clear so that there will be less exposure to the vagaries of a country-by-country judicial process.
This commentary also will appear in the May 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions, and Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, and in Tax Practice Series, see ¶2330, Interest Expense, and ¶3600, Section 482 - Allocation of Income and Deductions Between Related Taxpayers.
2 I actually find the term "double non-taxation" to be intriguing and I wonder who coined it. Seems purposely provocative and all of the examples cited really are at best single non-taxation or even merely single lower taxation. There's one amount of income that at best is not taxed by either country involved in the transaction. Seems at most single non-taxation to me. None of the other countries in the world tax that income either, but that doesn't make it multiple non-taxation, does it?
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