INTM552070 - Hybrids: hybrid transfers (Chapter 4): conditions to be satisfied: condition A - substitute payments

A substitute payment is defined in s259DB(5) as a payment or quasi-payment that

• consists of or involves an amount paid or a benefit given
• is representative of a return arising on, or in connection with, the underlying financial instrument, and
• is paid or given to someone other than the person to whom the return on the underlying instrument arises

Payment or benefit

Normally a substitute payment is an actual payment. However, there might be a benefit rather than an actual payment if amounts are netted off or where there are less obvious or more contrived arrangements for transferring value, such as by means of a loan waiver.

A substitute payment may become payable where an economic owner of securities is deprived of a dividend or interest payment that would be expected to arise to it as economic owner of the asset. This may arise because the economic owner has lent the security under a repo or stock loan arrangement and expects the security to be transferred back at a later date, and during this period an amount of interest or a dividend is paid.

If a repo (see INTM552040) or stock loan (see INTM552050) extends over the record date (the date which determines to whom the dividend or interest on the underlying instrument will be paid) the registered holder (the transferee) of the securities on that date is entitled to the interest or dividend. Commonly, under the terms of the stock lending or repo arrangement, the transferee will be required to compensate the original transferor by means of a substitute payment.

Substitute payments are very common in the financial markets. There may be a chain of substitute payments, for instance if shares are lent to an intermediary, and then on-lent to a further party who sells into the market intending to repurchase similar shares in the market at a later date.

Representative return

The amount must be representative of a return of any kind on the underlying instrument. Accordingly, it need not be the same as a gross dividend or interest payment, because withholding tax effects, etc. may have an impact.

For example, if a dividend of 100, payable to the original holder of the shares, would normally be paid subject to a withholding tax of 15% (depending on the jurisdiction of residence of the issuer of the security), the substitute payment might be reduced to 85.

A stock lending or repo transaction might be used to position securities over the record date, with a view to reducing or eliminating the withholding tax levied on an actual dividend or interest payment by the issuer’s jurisdiction. In these circumstances, the substitute payment might be some amount in-between 85 and 100, sharing the benefit of the reduced withholding tax between the parties.

This form of tax arbitrage is not within the scope of the hybrid mismatch rules. To the extent that such withholding tax arbitrage impacts on pricing, this is not taken into account in determining whether there is a ‘structured arrangement’ for the purpose of the hybrid mismatch regime.

Substitute payments and failed delivery

Substitute payments are not limited to those made in stock lending and repo arrangements. For example, a company might enter into a contract to sell securities cum dividend (that is, including the right to the dividend) but for some reason, perhaps because of a delay in delivery resulting from a failed trade, title to the securities might not pass until after the record date for the dividend or interest in question; the securities are thus delivered ex-dividend. Typically, the sales contract will require the vendor to make a substitute payment (which might be described as compensation) to the purchaser in such circumstances – thus the substitute payment is made in reverse by the transferor to the transferee.

A failed delivery that gives rise to a substitute payment, whether unintended or deliberate, falls within s259DB(2)(c) as an example of any other arrangement.

Substitute payments and condition A

The question of whether a substitute payment could be made is determined by the actual contractual arrangements. There is no need to consider whether there could have been alternative arrangements with similar economic characteristics under which a substitute payment could have arisen. If a substitute payment is possible, condition A is satisfied even if no substitute payment is made.

Note that although condition A is satisfied where a substitute payment could be made, a mismatch cannot arise if a substitute payment is not actually made.