Addressing Tax Arbitrage with Hybrid Financial Instruments: A Multidisciplinary Study and Proposal for Developed and Developing Countries

In many different circumstances, hybrid financial instruments (HFIs) can be an appealing source of finance. At the same time, however, such instruments may also be used in tax planning. Its differential treatment in the affected jurisdictions can give rise to double non-taxation of a payment. Exploiting this allows for significant reductions in corporate tax liability. In the aftermath of the recent financial crisis, such “tax arbitrage” has increasingly been a topic of debate within the G20, OECD, European Union and United Nations. As a result, various concepts of how to address the problem were developed. Besides these, some states already rely on provisions that can be of relevance in this context. Starting from these developments, the objective of this book is to help those in charge of solving the problem make a more educated decision. As such, it addresses tax policymakers around the world. For the sake of reaching its goals, the book applies the socio-legal method. This should acknowledge that tax policymakers design rules in a context that is broader than existing tax law. They have to consider the traditional principles of tax policy, including tax competition constraints, as well as legal dogmatic restrictions – as does this book. In chapter 1, the reader is introduced to the topic and the design of the
research. In chapter 2, HFIs are illuminated from the perspective of tax law, corporate finance and economics. The goal is to understand their role in reality. In chapter 3, the guiding principles for company taxation are reviewed. Contemporary tax research relies on the triumvirate of equity, efficiency and administrability. The literature on these issues is considered in sufficient depth, but with a strong focus on the research objectives. Chapter 4 builds a bridge between the above preparatory part and the core research. This happens by working out the non-legal concerns attached to tax arbitrage with HFIs. They include three concerns from an inter-taxpayer equity perspective, three from an inter-nation equity perspective and three from an efficiency perspective. This defines the problem. Chapters 5-8 investigate how four approaches address these concerns. These are the OECD approach, the low-tax approach, the UN approach and the recharacterization approach. The focus is on tax arbitrage transactions with HFIs that rely on a qualification conflict and substitute transactions with financial instruments that reach the same or a similar result. The research on these approaches also takes into account their administrability and legal dogmatic considerations. In doing so, the collateral damage caused by the rules is assessed as well. This also happens from a multi-disciplinary
perspective. In chapter 9, the author presents his own thoughts on what
developed and developing countries may want to consider when dealing with
the problem of tax arbitrage with HFIs. The author is aware of tax arbitrage with HFIs only being a part of the challenges that tax policymakers have to deal with. In an attempt to consider this, the discussion is put into a broader context. As a direct consequence thereof, the book lacks a clear solution. Rather, it aims to provide information that should improve tax policymakers’ ability to address the issue. It is left up to them to trade off equity, efficiency and administrability considerations, paying attention to what is possible de lege lata and, notably, taking into account what best fits their countries’ and tax systems’ needs.