INTM552040 - Hybrids: hybrid transfers (Chapter 4): conditions to be satisfied: condition A - what are repos

A repo is a type of in-substance lending (see CFM46100). In its simplest form, the in-substance borrower transfers a security (the underlying financial instrument) to an in-substance lender at a price, say £100. The in-substance borrower agrees to repurchase the same security (or an identical security) on a fixed future date at an agreed higher price, say £101. Economically this is equivalent to a loan of £100 secured on the transferred securities, bearing an interest-like funding cost of £1.

There are many variations on the theme. For instance

• the prices could be set in any currency (but the same currency for both sale and repurchase)
• there may be flexibility as to the relevant dates and the repurchase price may be fixed by a formula, essentially the accretion of interest over time on the original transfer price
• the nature of the securities to be redelivered may be the actual securities delivered or there may be flexibility for the in-substance lender to deliver securities similar, but not necessarily identical, to the original securities, with the same value as the securities originally transferred

Adjustments may need to be made if interest or dividends become payable on the underlying securities in the interim. The in-substance lender may be required to make a substitute payment (see INTM552070) to recompense the in-substance borrower for the actual dividend received, or the repurchase price may be reduced.

Example

• Securities are transferred from Co. 1 (the in-substance borrower) to Co. 2 (the in-substance lender) for £100, under an arrangement such that Co. 1 will repurchase them for £101 in 4 months’ time
• During this period Co. 2 becomes entitled to a dividend payment of £4 on the underlying securities
• Co. 2 may be obliged either to make a substitute payment of £4 to Co. 1 or to reduce the repurchase price payable by Co. 1 at the end of the period from £101 to £97

If Co. 1’s jurisdiction treats this arrangement as secured borrowing, Co. 1 (the in-substance borrower) is likely to be treated as receiving the dividend of £4 on the underlying financial instrument and as having incurred a funding cost of £1 on the repo. The receipt of £4 may be non-taxable under a portfolio dividend exemption.

If Co. 2’s jurisdiction also treats this arrangement according to its economic substance, Co. 2 (the in-substance lender) is likely to be taxed on an in-substance interest amount of £1, with the transfer and retransfer of the securities and the receipt of the dividend of £4 being ignored. No tax mismatch would arise in these circumstances.

But, if Co 2’s jurisdiction taxes the arrangement purely on the legal form of the transaction, Co 2 is likely to be regarded as having made a capital loss of £3 (cost £100, sales proceeds £97). If the actual dividend actually received by Co. 2 is non-taxable, then a mismatch arises.