In the presence of hybrid instruments, the universe of financial 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 differently, there is a scope for international tax planning: foreign investment financed with a hybrid instrument treated as debt in the host country and equity in the home country combines the benefits 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 inefficiency typically derives from the endeavors of policymakers to draw lines in ways that facilitate hybrid financing by domestic multinational firms and impede hybrid financing by foreign multinational firms with a view to eroding foreign taxation of domestic firms and enforcing domestic taxation of foreign firms.
