Strategic Line Drawing between Debt and Equity

In the presence of hybrid instruments, the universe of ?nancial instruments becomes a debt-equity continuum and corporate tax systems, which generally maintain a sharp distinction between debt and equity, need to draw lines that distinguish the set of debt instruments from the set of equity instruments for tax purposes. When countries draw lines between debt and equity di¤erently, there is a scope for international tax planning: foreign investment ?nanced with a hybrid instrument treated as debt in the host country and equity in the home country combines the bene?ts of tax deductible interest payments in the host country and tax favored dividend payments in the home country. This paper develops a theoretical model of strategic line drawing between debt and equity in the presence of hybrid instruments. In the absence of international cooperation, lines are generally drawn in a globally suboptimal manner. The ine¢ ciency typically derives from the endeavors of policymakers to draw lines in ways that facilitate hybrid ?nancing by domestic multinational ?rms and impede hybrid ?nancing by foreign multinational ?rms with a view to eroding foreign taxation of domestic ?rms and enforcing domestic taxation of foreign ?firms