jonathan crowther explains the bewildering array of different securities available
A security is a means of participating in a business, utility or government body. The participation is usually in the form of debt or equity, where the downside risk is limited to the amount invested. This contrasts with participation in ventures such as Lloyd"s of London or enterprises such as professional partnerships where the downside risk can be unlimited. Specific balance sheet assets, such as mortgage debts, can also be securitised, as can specific income flows, such as gilt "strips" (specific future interest payments on UK government debt dealt with as securities in their own right).
stocks and bonds
The distinction between debt and equity is crucial for the issuer since the interest paid on a debt security will be deductible for tax as a charge against income whereas a dividend paid on an equity security will not since it is a distribution of income. Clearly, issuers will be tempted to categorise equity participation as debt and thin capitalisation rules have been developed in most jurisdictions to challenge this strategy.
To complicate matters further, debt is often issued which can be convertible into equity. In addition a "meta market" of derivative securities has developed based on a wide variety of buy and sell strategies.
The result is a financial jungle inhabited by such species as ordinary shares, preference shares, cumulative preference shares, debentures, deep discount bonds, deep gain bonds, negotiable CDs, dual currency bonds, duet bonds, commodity-linked bonds, bull and bear bonds, annuity notes, bunny bonds, flip flop notes, mortgage pass through securities, debt with equity warrants, floating rate preferred stock, forward contracts, futures contracts, options, swaps, swaptions, repurchase agreements, to mention but a few, which appear to offer every possible combination of risk and reward to the investor.
These types of security, which represent interests in the directly invested capital of a venture or enterprise, must be distinguished from securities issued by collective investment schemes such as unit trusts, investment trusts, Oeic"s, mutual funds, limited partnerships for example, which themselves securitise a portfolio of underlying securities. These schemes are investment vehicles, often established in offshore finance centres, whose own securities can come in a number of forms, for example, redeemable preference shares versus market traded shares.
Given this situation, the question "what is the security?" can only be answered in practice by examining the security"s issuing documentation and taking advice on the effects of owning it.
For instance, a eurobond which qualifies as a qualifying corporate bond has a tax treatment different from one that does not qualify. Many debt securities are issued through the eurobond market and the domestic tax regimes of the issuers specifically allow interest on eurobonds to be paid gross (Italy being a notable exception). A eurobond is a bearer security, although in practice it is difficult, if not impossible, to take physical delivery, held in the designated account of an authorised nominee such as a bank.
For the UK expatriate who is UK domiciled, certain gilts are treated as excluded property for inheritance tax for individuals not ordinarily resident in the UK, and so present a relatively unique opportunity for inheritance tax planning using fixed interest securities. Unquoted shares, say in an owner manager"s company in the Middle East, and securities quoted on the UK"s Aim exchange are exempt from inheritance tax, subject to certain conditions, and present opportunities for inheritance planning using private and publicly quoted equity-based securities.
Where the security is located is usually where its register is located. If securities are traded on different exchanges then there will be several registers. Normally, registers record only the nominee details, with individual investor details being held by the nominee. In an increasingly dematerialised world with T+3 settlement, holding certificated securities will in future become an expensive luxury for an individual investor. This raises the whole issue of the status of the nominee for tax and estate planning purposes. This matter will be discussed in a future article. However, a nominee is no trustee at all and securities held on a register in a nominee name in a jurisdiction potentially will be subject to the income, gains, wealth and inheritance taxes and the probate and inheritance rules of that jurisdiction.
Interest paid on a eurobond issued by a UK company is UK source income, albeit exempt income under the rules for non-residents issued in Finance Act 1995. It is difficult to find a definitive answer to the question whether UK issuer eurobonds are liable to UK inheritance tax. The various views revolve around the interaction of the terms of issue, the residence of the issuer, the location of the register and the fact that they are bearer bonds. The Revenue Manual states that "the situs of securities dealt with through computerised clearing systems (for example Euroclear) is regarded as determined by the terms of issue of the particular security."
So, to answer the question "who owns the security?" is rarely as simple as the name of the person on the register.
If a security is held in an offshore fund via an insurance or redemption policy, then the Revenue take the view that the insurance company is the legal and beneficial owner of the offshore fund, following the Willoughby case. However, since offshore and onshore insurance companies are usually wholly-owned subsidiaries of UK resident companies, the offshore fund represents a controlled foreign company (CFC) for the UK holding company. If the underlying security is a gross interest paying security, then the UK holding company can be assessed on the interest under the CFC rules, despite the fact that the economic owner of the policy, and therefore the offshore fund and the underlying debt security, is the grantor of the policy. The simple answer to this problem is to use a UK Oeic rather than an offshore fund since a UK resident Oeic cannot, by definition, fall within the CFC regime.
The EU Savings Tax Directive (STD) will result in paying agents having to determine who owns debt claim securities (which include both fixed interest securities and collective investment schemes holding such securities) in an unprecedented manner. Unlike the US Qualifying Intermediary regime or the UK NORA regime, the STD is not a self-declaration system and the paying agent is tasked with determining both the identity of the beneficial owner of the debt claim and where they are resident in order to apply retention or exchange. This involves a "residual entity" analysis to determine whether a non-individual owner is a mainstream entity (for example, a legal entity, a business or a Ucits), and therefore outside of the scope of the Directive, or a paying agent, and responsible in turn for retention or exchange. Even where an individual is the registered owner of the debt claim, the paying agent must take "reasonable steps" if he "has information suggesting that the individual who receives an interest payment or for whom an interest payment is secured may not be the beneficial owner" to establish the identity of the real beneficial owner.
The question of when a security is issued, acquired and sold and income arises on it, gives rise to interesting tax planning techniques. One classic technique is "bond washing" whereby a debt security is acquired just after it has gone ex-div and sold just before it next goes ex-div. Under general principles, the investor realises a capital gain. The UK Government introduced anti-avoidance legislation some years ago, which taxed the accrued income element over the holding period, but generally this does not apply to non-residents.
Another technique is to issue fixed interest securities at a discount with no interest coupon. The discount is capital and so not taxable in the hands of the investor. Again this has been attacked, but a deep discount security is still an attractive method of financing a UK property deal since there is no UK withholding tax on a discount whereas annual interest paid to a non-resident must be paid under deduction of income tax. These techniques may well work in countries where such anti-avoidance legislation has not yet been introduced.
date of issue
The EU STD will bring the date of issue of a debt security into sharp focus since under Article 15 of the Directive securities issued (or for which the original issuing prospectus has been approved) before 1 March 2001 are grandfathered and do not qualify as debt claims for the purpose of retention tax or exchange of information. This means that many bond funds will remain outside the scope of the Directive so long as their portfolios are appropriately structured.
Why a security is transacted can impact whether the transaction is treated as trading or investment in the first instance under general principles. However, anti-avoidance legislation can be either automatic or subject to an intention to avoid tax and so the reason for undertaking a security transaction can determine whether it is within certain anti-avoidance legislation. In particular, the UK has ICTA 1988 section 703 which specifically attacks "tax advantages from certain transactions in securities" unless it can be shown that "the transaction or transactions were carried out either for bona fide commercial reasons or in the ordinary course of making or managing investments and that none of them has as its main object, or one of its main objects, to enable tax advantages to be obtained". In any tax or estate planning involving securities, section 703 must be constantly borne in mind.
Next month"s article will look at the categorisation of land and buildings or real estate.
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