Tax treatment of hybrid instruments

On 19 June 2024, Malaysia´s Inland Revenue Board (IRB) has issued the Guidelines on Tax Treatment of Hybrid Instruments.

Below please find the salient points of these guidelines:

Key features of debt or equity instruments

The key features of equity and debt instruments are:

Equity	Debt
Entitles to a share of distributions or profits (i.e. dividend)	Right to distributions or profits is fixed
Entitles to residual assets of the company after the repayment to debt holders upon liquidation	Entitles to the reimbursement of the principal amount of debt during liquidation
Does not have any maturity date	Does have a maturity date
Does have voting rights	Does not have any voting rights
The management of the entity has the discretion to make a payment of distributions or profits	The instrument holder has the legal right to demand the payment of distributions or profits.

How to determine whether a hybrid instrument is a debt or equity instrument for tax purposes

The determination of whether a hybrid instrument is an equity or debt instrument should be based on substance over form.

Below are the criteria (in order of priority) for the classification of a hybrid instrument (please note that this list is not exhaustive):

	Equity	Debt
Source of repayment of capital and payment of distributions or profits; and The order of repayment in the event of liquidation or dissolution	the source of the repayment depends on the retained earnings or the tied-up reserve; In the event of liquidation or dissolution: the priority of repayment of the principal is lower for an instrument holder than for a general creditor or subordinated debt holder; or the holder of the instrument may suffer a loss incurred by the issuer which could reduce the principal amount of the instrument.	repayment is not dependent on the profits of the issuer of the instrument (regardless of the financial situation) and the payment obligation is cumulative; or the payment of distributions or profits is mandatory and/or cumulative. The existence of a dividend stop is not decisive for the classification of the instrument as a debt instrument.
Right to enforce payment of distributions or profits and repayment of the principal by the instrument holder.	The instrument holder has no option to enforce payment.	The instrument holder has the unrestricted right to demand payment. Debt instruments usually contain a “default and enforcement” clause.
In the event of default	The holder of the instrument has no right or contingent right to the repayment of the principal amount or accumulated distributions or profits.	The holder of the instrument has the right to recover the principal amount, subject to a step-up feature.
Maturity date of the instrument	There is no fixed redemption date or step-up feature.	The instrument has a fixed redemption date or a step-up feature.
The ability of the issuer to obtain a loan and make payment at an arm's length price.	The terms are unreasonable and not at arm's length.	The issuer is able to obtain a loan and to meet payment obligations in a transaction at arm's length.
Participation in the management	The instrument holder has a right to vote at the General Meeting.	The instrument holder has no voting rights at the Annual General Meeting. Certain instruments have the characteristics of an equity instrument, although there is no right to participate in the management.
Benefit for the holder of the instrument	The holder of an equity instrument generally invests in the instrument in the expectation of profit participation and long-term capital appreciation of the investment value.	The holder of the instrument generally invests with the expectation of a return on the amount invested (a steady stream of recurring income over the life of the investment), regardless of the profitability of the company, and does not expect any capital appreciation on its investment.

Tax treatment of debt instruments and equity instruments

	Equity	Debt
Payment arising from instrument	Profit distribution; For shareholders, it takes the form of a dividend.	Interest
Tax treatment for issuer	Expenses incurred in connection with the payment or distribution are not deductible under section 33(1) of the Income Tax Act 1967 (“ITA”).	Interest expenses are deductible if the interest expenses correspond to the ITA.
Tax treatment for instrument holder	Dividends received from a Malaysian resident company are exempt from tax under paragraph 12B, Schedule 6 of the ITA; Foreign dividend income is taxable in Malaysia except for amounts received in Malaysia between January 1, 2022 and December 31, 2026 which are specifically exempt from tax and subject to certain conditions; Distributions from Real Estate Investment Trest are taxable depending on the profile of the unit holders.	Interest income is taxable unless it is expressly exempt from tax.

Islamic hybrid instruments

Sukuk is an Islamic financing instrument complying with Shariah principles. Depending on the underlying Shariah contracts, sukuk can be structured as equity or debt. The key features are as follows:

Equity	Debt
Structured based on the principles of Musyarakah or Mudharabah. The profit from the ventures is shared according to the pre-agreed profit share, there is no guarantee of the profit rate and a reduction in the value of the capital/capital if the contract suffers a loss.	The expected profit rate is fixed and guaranteed, can be deferred and the repayment of the capital is guaranteed.

Although the modus operandi of Islamic hybrid instruments for the payment of distributions or profits differs from that of conventional hybrid instruments, other factors discussed in Note 2 can be applied to determine whether the Islamic hybrid instrument is equity or debt in nature.