Bloomberg Tax
July 8, 2020, 7:01 AM

INSIGHT: How Companies Could Benefit from Ending the Pro-Debt Bias in Taxes

Michael  Troege
Michael Troege
ESCP Business School

The Covid-19 crisis has revealed that many companies have too high leverage. An easy way to fix this would be to make equity cheaper by making it tax deductible. This would not only lead to more balanced capital structures but also decrease the cost of finance and boost investment. There are several simple ways for doing this which have been successfully tested in other countries.

Ending the pro-debt bias of corporate taxation has been on the agenda ever since the U.K.’s Institute for Fiscal Studies proposed a fundamental pro-business tax reform almost 30 years ago. Since then the Mirrlees Review, the OECD, the IMF, the European Commission and the EU’s High Level Forum on capital markets union have all pointed out the need for ending the effective tax penalty on equity. Surprisingly, instead of fixing this problem, a number of tax reforms have worsened the situation over the last 20 years.

The Problem

The fundamental problem is well known: companies can raise finance through debt or equity, but the return on these two types of finance is taxed differently: interest is tax deductible whereas dividends are not. This pushes companies to take on more debt than they should. As a consequence, firms are not only less robust to external shocks, such as the actual Covid-19 crisis, but they also invest less and engage in overly risky business strategies. The tax asymmetry particularly harms small and medium-sized entities (SMEs) who face higher borrowing constraints than larger companies and are therefore less able to reduce their tax bill by simply altering their capital structure.

Until the end of the 1990s most European countries were operating different variants of imputation systems, where shareholders were able to claim a tax credit for the corporate tax paid by a company. This mechanism significantly reduced the tax disadvantage of equity. When these systems were abandoned (in 1997 in the U.K., in 2000 in Germany and in 2004 in France) this resulted not only in a stealth increase of corporate taxation, but also in a massive and presumably unintentional tax advantage for debt. Not surprisingly, companies reacted by starting to increase their leverage ratios.

In the U.S. a different set of reforms produced a similarly spectacular increase in the pro-debt bias of corporate taxation. Until the mid-1980s in the U.S., the tax advantage of interest at the corporate level was offset by a tax disadvantage at the level of investors that kept the tax system roughly leverage neutral. This changed when income taxes started to fall throughout the 1980s and 90s. In addition, the raise of offshore finance has substantially reduced the effective taxation of interest income, creating again a substantial increase in the relative advantage of debt followed by a massive increase in overall corporate leverage.

Rather than fundamentally addressing the problem of tax bias in favor of debt, governments have tinkered with tax laws and introduced a number of ad hoc rules to cut down on the most egregious tax optimization schemes. This includes the “Corporate Interest Restriction” recently introduced in the U.K. in 2017, the German “Zinsschranke,” the “rabot fiscal” in France, and the “interest deductibility cap” that comes with the recent Trump tax reforms in the U.S. These rules limit the deductibility of interest to an arbitrarily chosen level, typically 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). This not only constrains the firms in their choice of capital structure but also disadvantages certain businesses, such as car dealers, that by the nature of their business work with high levels of debt.

A Simple Solution

This is a pity because a clean simple solution exists that would tax equity and debt symmetrically. In principle this can be done in two ways: either the taxation of debt can be aligned with that of equity, or equity needs to be treated in the same way as debt is treated today. Both systems have been analyzed in great detail by researchers and tax authorities. The first solution corresponds to making both dividends and interest non-deductible. This type of tax is normally referred to as CBIT (comprehensive business income tax). The second system would imply tax deductibility not only of debt but also of equity. It is usually referred to as an ACE (allowance for corporate equity).

A CBIT, i.e. the abolition of interest deductibility, is intuitively attractive, but has major practical and theoretical disadvantages. Most importantly of course, a CBIT-type reform would consist in an effective increase of corporate taxation, unless the corporate tax rate is substantially reduced. At the same time the taxation of investors needs to be reduced so as not to penalize debt massively. No country has so far dared to undertake a tax reform on this scale.

A CBIT system also has theoretical properties that make it unattractive. In particular, it would increase the cost of capital, making many investments unprofitable. One can therefore expect a decline in the level of investment after the introduction of a CBIT, which could affect the competitiveness of companies and economic growth.

The interest of the second system, the ACE, is to avoid all these shortcomings. It not only aligns the taxation of equity and debt but can be added to the existing tax structure without the need for additional reforms and has been successfully tested in several countries, notably Italy and Belgium.

Finally, the ACE system has very attractive theoretical properties. Unlike CBIT and the current tax system, an ACE eliminates taxation on marginally profitable investments and thus encourages investment. This is the main reason this system was developed.

The functioning of an ACE-type reform is simple. The government defines a “notional interest rate” for equity capital. In order to achieve tax neutrality, a rate close to the average interest rate paid by companies on their debt should be used. Using this rate, “notional interest” is calculated for the company’s equity capital, which is tax-deductible, similar to the interest paid by the company on its debt.

It is easy to understand that this type of ACE tax is leverage neutral: if the company replaces equity with debt, it will increase its cash interest but also decrease its notional interest. With a notional rate identical to the real rate, overall taxable income will remain the same. This system can even be calibrated to make equity more tax advantageous than debt. If the real rates are higher than the notional rate, we obtain a (small) advantage for the debt. On the other hand, if the notional rate is higher than the real rate, a tax advantage is generated for companies with low debt and thus a tax incentive to finance with more equity. Obviously, overall an ACE would result in a reduction of the tax load for most companies, but given the low level of interest rates and equity levels this effect should be quite limited.

Small owner-financed firms would particularly benefit from this scheme; not only because they typically have lower leverage than larger more stable companies, but also because they often have a lower return on equity (ROE) than larger firms. Note that if the ROE is lower than the notional cost of equity the ACE will reduce the company’s taxable profit to zero. This is an attractive property because it means that struggling companies will not be penalized by excessive taxation.

Going Forward

Apart from inertia, there does not seem to exist a good reason not to introduce an ACE reform. Unlike most tax laws, this reform is not only simple; it has also proven to be effective. Both in Italy and Belgium ACE-type tax reforms have led to a decrease in leverage and an increase in investments. Ad hoc measures such as the deferral of certain value-added tax and income tax payments are nice to get, but will only have a short-term impact.

What the U.K. needs in order to emerge from the Covid-19 crisis is a smart tax reform that increases the resilience of U.K. businesses by providing incentives to adopt a sound capital structure.

Michael Troege is Professor of Finance at ESCP Business School, Paris.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Learn more about Bloomberg Tax or Log In to keep reading:

Learn About Bloomberg Tax

From research to software to news, find what you need to stay ahead.

Already a subscriber?

Log in to keep reading or access research tools.