We need to do more to help companies finance their activities
Tom Maguire Sunday Business Post Column
What a week! As a result, tax policy will be the subject of debate for some time but the EU Commission recently published its 100+ page 2020 survey on Tax Policies in the European Union. It contained commentary on Member States’ policies but one stood out.
Simple question: debt or equity funding? That’s what companies have to decide when seeking investment. If a company is debt financed then it gets a tax deduction for interest on borrowings used to finance its activities where certain Ts and Cs apply. If it finances itself with equity then nothing, nada, zip. This dilemma has the catchy title of the “corporate debt bias”.
Okay, corporate interest deductions are due to change shortly to accord with the EU’s Anti-tax Avoidance Directive (ATAD). This will limit future corporate interest deductions. That also means that the provisions in our law will be amended and hopefully simplified in the process. For example, one interest deduction started life back in 1974 at just over three quarters of a page; now it weighs in at almost ten pages. That’s due to all the additional hoops added since then that taxpayers have to jump through. Say the words “two-four-seven” to any tax adviser (that’s the section of law at issue) and watch their reaction, I dare you! Simplicity eats complexity for breakfast when it comes to investment; even with ATAD there will still be an interest deduction on debt with nothing on equity. That needs fixing.
The EU Commission’s document explains that the corporate debt bias “contributes to financial stability risks, e.g. by increasing the probability of bankruptcy”. It continues that the higher cost of equity finance “is particularly problematic for young and innovative companies, which often have no access to external debt funding”. Limited access to alternative finance sources e.g. venture capital, compounds this. It explains that several Member States have introduced incentives to promote venture capital and business angel funding, but these types of finance represent only a small proportion of the total funding mix. Consequently, small and innovative businesses might be at a disadvantage, despite their importance in generating future growth. You can see their point.
The EU document outlines solutions to the corporate debt bias. First, eliminate interest deductions, which can reduce investment: Bad answer. Anyway it would put us in a significantly less attractive position with competing nations, so non merci mes amis. The second is to extend tax deductibility to the return on equity (e.g. allowance for corporate equity (ACE) reform or ‘notional interest deduction’) or to grant tax deductions irrespective of the mode of financing. There are others but I’ll stick with the ACE here.
The EU’s report notes that there are differing factors in determining the attractiveness of an ACE including (1) the applied notional interest rate; (2) how the deductible amount of equity is established. It also cites the absence of comprehensive anti-abuse provisions as an attractive factor. That’s why the report recommends that it is important that ACE regimes contain “strong and comprehensive anti-abuse provisions” to prevent them being used for aggressive tax planning.
When we enact new provisions in this country, we bring about significant anti-avoidance provisions with them. Remember the ten page example earlier! Indeed if they fail then the General Anti-Avoidance Rule can apply which says that if it is “reasonable to consider” that an arrangement was done to avoid tax or to claim a relief, which an ACE would be, and where that claim constituted an abuse of that relief then no tax advantage can apply. The test is a “reasonable to consider” test rather than a “beyond a reasonable doubt” test and so it’s a low bar where someone (company, individual or other entity) is acting the Michael with tax.
The EU report explains that notional interest rates can vary substantially but ideally, they should approximate the normal return to debt, i.e. the riskless interest rate. This rate could be supplemented with a risk premium. Given the different economic situations in Member States, this represents a first source of variation. The report explains that in Cyprus, the notional interest rate depends on the domestic rate in the country from which the funds are invested. The idea is to eliminate the tax bias between debt and equity and therefore the more the equity test resembles debt then the more bias that’s relieved.
The report also explains that a broad distinction can be made as regards the equity base: either it covers the full amount of equity or only new equity can be deducted (‘incremental’ ACE schemes). It explains that while both types offer economic incentives to reduce debt and increase investment, the former also provides firms with windfall profits presumably from the fact that where a company was previously equity funded then the equity which it obtained years ago can now claim a tax deduction. Of the five examples quoted in the EU report, the 2019 tax base of Belgium, Cyprus and Portugal applies the deduction to “new equity” whereas Malta and Poland apply it to full equity stock.
Even the EU Commission’s proposed Common Consolidated Corporate Tax Base (CCCTB) - Remember that one? - contains an "allowance for growth and investment" which gives a form of equity deduction. The former Finance Minister Michael Noonan noted that the CCCTB proposal for a form of ACE "makes an interesting case for giving tax relief for equity investment in a business, which is something which should be examined further". We haven’t done it yet and it must be remembered that the EU report explains that there is evidence from evaluating ACE regimes in Member States that suggests they have been largely effective in reducing the corporate debt bias. Given international tax law differences, the ACE should be at least optional for a taxpayer to elect into.
The EU report outlines the dark side to the tax corporate bias which I’ve mentioned above. Many general election manifestoes are all about helping business to live, thrive and survive which is exactly the opposite of the dark side of the corporate debt bias. Myron Scholes (Nobel prize winner in economics) and others said that when it comes to tax, success is achieved when the tax rules subsidise activities that benefit society as a whole more than they benefit the individuals engaging in the activities. So now is the time to act on this or at least as part of the first 100 days, when that clock starts ticking.