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Review of Quantitative Finance and Accounting

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13.12.2017 | Original Research

The effects on investment incentives of an allowance for corporate equity tax system: the Belgian case as an example

verfasst von: Carmen Bachmann, Martin Baumann, Konrad Richter

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2018

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Abstract

In the past years, allowance for corporate equity (ACE) tax systems have become more popular even though they are still quite rare. An ACE tends to make a tax system neutral in respect of whether a company is financed by debt or equity. Less attention is given to the effects on investment incentives by scientific literature. We construct a model based on the principle of a hurdle rate to show whether and how an ACE system could change a company’s decision between distribution and reinvestment. The analysis is extended by implementing the so called fairness tax. We find that the influence of the fairness tax on (re)investment incentives depends on the debt to total capital ratio and the return on equity. Hence, the introduction of an ACE does only in certain cases lead to a change from distribution to reinvestment. Interestingly, the fairness tax can increase the incentive to reinvest in few situations and can make the ACE system more attractive in respect of reinvestment.

Vorheriger Artikel Derivatives usage for banking industry: evidence from the European markets

Nächster Artikel Glamour versus value, market timing and firm performance: evidence from mergers and acquisitions

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See also Wenger (1983) who proposed it regarding the equality of taxation of earned and capital income. See Bond and Devereux (1995) who extended the idea of Boadway and Bruce (1984) for uncertainty.

For an analytical overview about ACE systems in practice see Klemm (2007) and for economic implications of ACE reforms De Mooij and Devereux (2011). Hebous and Ruf (2015) present a list of hard and soft ACE systems.

For the impact of the Austrian tax reform on the capital structure see Frühwirth and Kobialka (2010).

For an analysis of the former Italian tax reform see Staderini (2001) who found a decrease in leverage and an increase of retained earnings, both depending on the profitability and productivity of the firms.

For a detailed discussion of the Croatian ACE system see Keen and King (2002).

For details see Staubli and Küttel (2013). In February 2017 the proposal of a notional interest deduction was rejected in a national referendum as part of the corporate tax reform III.

For details and alternative designs see Freebairn (2016).

See Gordon (2011) who prefers an expenditure tax system with a business cash-flow tax instead of an ACE system for the UK.

For an analysis of the ACE system as an alternative to thin capitalization rules see Rumpf (2009).

To avoid this, Boadway and Bruce (1984) proposed an Allowance for Corporate Capital (ACC) system, in which the interest deduction is abolished and replaced by the deduction for the notional risk-free return on all capital. In the ACC system it is totally irrelevant whether the company is financed by equity or debt.

The Belgian NID applies from tax year 2007 onwards. For details see art. 205 of the Belgian Income Tax Code and Peeters and Hermie (2011).

Basis of calculation are the months July, August and September of the preceding tax year.

Alternatively, if the participation amounts to at least 2.5 million EUR.

See Aus dem Moore (2014), who refers to the explanatory memorandum no. 51-1778/001.

For details see art. 219 and 233 of the Belgian Income Tax Code. According to the ECJ (2017), the fairness tax partly infringes the Parent-Subsidiary Directive.

The hurdle rate represents an established approach to measure the implementation of new tax rules. For example, it was used to measure the effects of tax law changes in Germany (Schultze and Dinh Thi 2007) and the introduction of the dividend exemption system in Japan (Bachmann and Baumann 2016).

For the value and the determinants of the debt tax shield see Menichini (2017) and for the valuation in different debt scenarios Couch et al. (2012).

The basis for the calculation is the total amount of net equity. According to the Belgian NID system we do not cap the interest on equity on so called new equity.

To abstract from the specific circumstances of the parent company, we assume the received dividend has no influence on the effective tax rate of the parent company. In practice, the dividend could increase the equity and therefore the ACE of the parent company if it is not resident abroad but the relevant equity would be reduced by the participation in the subsidiary.

It is a simple multiplication of the three factors dividends \( Y_{t - 1}^{C} \), tax rate t _p and the fraction of taxable dividends α. Obviously, the order of the factors is irrelevant.

For a derivation of Eq. (11) see “Appendix 1”.

For a detailed derivation of Eqs. (18) and (19) see “Appendix 2 and 3”.

In the case of a negative r _Equity, which we assume does not arise in our model, the lower hurdle rate has to be chosen.

The range up to 5% for i _E is realistic because the maximum NID rate in Belgium was 4.973% for SME in 2010 and has declined below 2% in 2016. A NID rate of 0% represents the case of no ACE system.

In the parent-subsidiary case withholding taxes are irrelevant. Even though they could apply in cross-border situations, they are often limited up to zero within the EU or due to double tax agreements. Furthermore, companies can often get a tax credit for the withholding tax.

This represents the maximum regular NID rate and is close to the average NID rate for the tax years 2011 to 2015.

Within the European Union, the Belgian corporate tax rate of 33.99% is one of the highest (France: 38%). In contrast, Bulgaria for example has a corporate tax rate of 10% (Eurostat 2015).

That outcome is similar to the effect of an increased debt tax shield due to higher corporate tax rates in a traditional tax system (e.g. Cheng and Tzeng 2014).

For example see Bahng and Jeong (2012) who investigated the debt ratios of Australian firms in relation to the firm size, the profitability and the tangibility of assets.

This holds for the case in which all other rates are constant in t − 1 and t.

The average of the five-year average return on equity rates amounts to approximately 8.91%, 10.55% respectively (excluding the negative rates), which supports our assumption of the above used rate of return on equity.

Notably, this does not illustrate the empirical comparison before and after introduction of the Belgian NID system because the used data are from periods where the NID system was in force.

The D/C ratios in Table 4 which are closest to the real D/C ratios of the companies are in bold.

As we assume a positive r _Equity (Sect. 4), we can abstract from a common tax loss carryforward while a tax loss arising from the NID cannot be carried forward.

For an example see Michel and Van den Berghe (2014).

It becomes obvious, that in case of reinvestment a lower fairness tax could apply as in case of distribution.

Whether an investor can really “save” taxes depends on the point of view (subsidiary or parent) and the basis of comparison.

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Titel: The effects on investment incentives of an allowance for corporate equity tax system: the Belgian case as an example
verfasst von: Carmen Bachmann
Martin Baumann
Konrad Richter
Publikationsdatum: 13.12.2017
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2018
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-017-0693-2

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