23 September 2019 - Article
For decades, hybrid instruments such as preferred stock, convertible bonds or perpetual securities have troubled tax authorities around the world. Exhibiting the characteristics of both debt and equity, they are commonly used as part of international tax planning strategies adopted by multinational enterprises in order to exploit differences in tax treatment of each instrument under the respective domestic laws of two or more jurisdictions. Specifically, the nature of the hybrid instrument may result in mismatched classifications by tax authorities at domestic law levels, thereby causing deductions to be allowed in one jurisdiction while leaving income in the other jurisdiction and, in some instances, double non-taxation, including long-term tax deferrals, may even result.
While there had been much discussion and debate on whether hybrid instruments ought to be classified as debt or equity, there was no international consensus on recognising the effects of the use of hybrid instruments as a 'global tax problem' until the launch of the Base Erosion and Profit Shifting ('BEPS') project by the Organisation for Economic Cooperation and Development ('OECD') and G20 members.
Action 2 of BEPS Action Plan: Coordination rules
To neutralise the advantageous tax effects of the hybrid instrument mismatch, the OECD and G20 members have proposed a comprehensive set of coordination rules to be implemented at domestic law level – see Hybrid Mismatch Arrangement under Action 2 of the BEPS Action Plan (published on 5 October 2015). In essence, the coordination rules require a jurisdiction to examine the tax treatment of the hybrid instrument by the counterparty jurisdiction when deciding the tax treatment to be accorded to that instrument by the first jurisdiction.
It must be emphasised that the coordination rules only address the mismatches in tax outcomes in respect of payments made under the hybrid instrument without affecting the commercial outcomes. As for the classification issue as to whether the hybrid instrument is debt or equity for tax purposes, it appears that this will be determined by the respective domestic laws of the various jurisdictions. There is still no international consensus on the universal approach to be applied.
The introduction of the coordination rules as part of domestic law does generate theoretical and practical difficulties – presently, tax, accounting and legal perspectives generally follow the characterisation accorded to the hybrid instrument provided for under domestic laws. Action 2 of the BEPS Action Plan, however, if implemented, may have the effect of creating a mismatch between tax, accounting and legal rules and principles. It is therefore crucial for countries intending to implement Action 2 of the BEPS Action Plan to consider its interaction with existing accounting and legal rules and principles.
Has Singapore adopted Action 2 of the BEPS Action Plan?
Although not a member of the OECD, Singapore has always been in the forefront of embracing OECD's recommendations to minimise tax arbitrage – in 2009, Singapore endorsed the internationally agreed Standard for EOI for tax purposes. This was developed further in 2011, 2013 and 2016, where steps were taken to extend EOI assistance and ultimately transition to an Automatic EOI regime in 2018.
As with most other jurisdictions, Singapore has monitored the BEPS project closely and has actively participated in BEPS discussions at various international fora. Singapore has, however, stopped short of expressing a clear intention to adopt the totality of the BEPS Action Plan, including Action 2, preferring instead to take a 'wait and see' approach. This is understandable since Singapore would need to juggle its need to maintain a pro-business environment and its status as an international financial hub and, at the same time, avoid being classified as a tax haven. In any event, Singapore would need to carefully consider the interaction between the coordination rules, existing domestic law (e.g. the general anti-avoidance provisions) and treaty policies.
What's next for Singapore?
Currently, Singapore has not enacted any tax legislation targeted specifically at hybrid instruments. Nor have there been any judicial pronouncements on the tax treatment to be accorded to hybrid instruments. In an attempt to provide some clarity to stakeholders (including issuers, investors and potential investors of hybrid instruments) on how such instruments would be treated for Singapore tax purposes, the Inland Revenue Authority of Singapore ('IRAS') issued an e-tax Guide on 'Income Tax Treatment of Hybrid Instruments' in May 2014.
From the e-tax Guide, the IRAS has indicated that the applicable tax treatment will follow the characterisation of a particular hybrid instrument. In determining the characterisation of the hybrid instrument, the IRAS will first establish its legal form by examining the legal rights and obligations created by the hybrid instrument − a hybrid instrument is generally characterised as equity if the legal terms of the instrument indicate ownership interests in the issuer. In the event that the IRAS cannot decipher the legal form of the hybrid instrument from its terms, the IRAS would then examine the facts and circumstances surrounding the hybrid instrument along with a combination of factors, including but not limited to the:
(a) nature of interest acquired;
(b) investor's right to participate in issuer's business;
( c ) voting rights conferred by the instrument;
(d) obligation to repay the principal amount;
(f) investor's right to enforce payment;
(g) classification by other regulatory authorities; and
(h) ranking of repayment in the event of liquidation or dissolution.
It is appropriate to highlight that these guidelines are simply that – practice guidelines, and are not backed by the force of law. Further, the e-tax Guide was issued prior to the publication of Action 2 of the BEPS Action Plan.
While Singapore is not likely to enact any specific tax legislation to tackle hybrid instruments or change the practice guidelines anytime soon, it will have to assess the need to re-negotiate its tax treaty agreements with its partners, in particular those will would be adopting Action 2 of the BEPS Action Plan. Singapore invariably may find itself adopting Action 2 of the BEPS Action Plan albeit at an international level vis-à-vis the tax treaty agreements without revision to its existing domestic law. It remains to seen whether this will be effective in neutralising the advantageous tax effects caused by mismatches arising from the use of hybrid instruments.
What should stakeholders do?
As the implementation of the BEPS project is still only in its infancy, stakeholders should start reviewing their transactions involving hybrid instruments so that they fall within the permissible boundaries dictated by the jurisdictions. In particular, Stakeholders should examine how payments under the hybrid instruments will be treated in the payer and payee jurisdictions following the implementation of the Action 2 of the BEPS Action Plan. More importantly, stakeholders should ensure that there are commercial reasons justifying the use of hybrid instruments since Action 2 of the BEPS Action Plan targets only at clearly abusive transactions. Stakeholders may also wish to consider engaging the respective tax authorities potentially interested in any proposed transactions involving the use of hybrid instruments.
*The writer wishes to acknowledge the assistance of Ms Rebecca Liu who is currently doing her training contract with the firm.