The Future of Business Taxation
Erasmus University
June 11, 2010
THE TAX TREATMENT OF
DEBT AND EQUITY
Michael P. Devereux
Questions
1. Why do countries attempt to treat
debt and equity differently?
2. Do they succeed?
3. Should we care?
4. Is the distinction sustainable?
5. What alternatives are there?
Oxford University Centre for Business Taxation
Two Starting Points
Comprehensive income tax:
• Tax individual on worldwide income
and increase in wealth
– irrespective of form of income or wealth
Consumption/expenditure tax
• Tax individual on current expenditure
= income minus net saving
– irrespective of form of saving
Oxford University Centre for Business Taxation
What is debt?
• Suppliers of debt have legal right to receive return
whatever the financial position of the borrower
• If borrower is insolvent, suppliers of debt have a
prior claim to income generated; equity receives
any residual after debt repaid
• Return to debt fixed in advance (in the absence of
bankruptcy); equity receives a variable return
• The suppliers of equity typically have control
rights; suppliers of debt typically do not
Oxford University Centre for Business Taxation
Hybrids
Any financial instrument which has some, but
not all, of these characteristics, e.g.
• Preference shares may pay fixed rate of
return, but not entitle holder to payment if
resources are insufficient
• Convertible debt: can be converted to equity
– value depends on which party can choose
to convert
• Covenants in debt contracts enable lenders
to control some activities of the borrower
Oxford University Centre for Business Taxation
So?
Do any of these factors justify different tax
treatment of debt and equity
• NO – at least not under the principles of
Comprehensive Income Tax or Expenditure
Tax
So why do we observe different treatment?
Oxford University Centre for Business Taxation
Why? One possible reason
One rationale for corporation tax: a proxy for
individual income tax on income derived from
equity investment
• Necessary because some profit is retained in
company, and difficult to tax at individual level
• But not necessary for “debt” instrument if return
received as interest by individual
So perhaps both taxed equally, but on different
occasions?
Oxford University Centre for Business Taxation
BUT
•
return on debt may not be cash receipt
– eg. value of corporate bonds change with
interest rate
•
return on equity partly takes the form
of cash payment, which could be taxed
at individual level
– So dividends could get tax relief as well
Oxford University Centre for Business Taxation
Why? Another possible reason
Or arguably the same one …
• Interest payments on borrowing are a
cost of doing business
– So companies (shareholders) should get
relief like other costs
Oxford University Centre for Business Taxation
BUT
•
•
Why tax companies at all: a
withholding tax on corporate income
owned by shareholders
Companies also collect and pay other
withholding taxes, eg.
– Income tax on employees
– Social security tax on employees
– VAT on customers (arguably)
Oxford University Centre for Business Taxation
BUT
•
Why not require companies to collect
withholding tax on interest paid to
creditors?
International issues:
– Why charge tax on foreign creditors?
– But why charge corporation tax on
foreign shareholders?
– Is there any reason for treating them
differently?
Oxford University Centre for Business Taxation
An aside: Financial Regulation
Financial Regulation should differentiate: but
for a clear rationale:
• reducing financial instability through
reduced probability of bank defaults
This reflects right of creditor to demand
payment, or put borrower into
administration/bankruptcy
Oxford University Centre for Business Taxation
So how does tax law differentiate?
UK
• Courts define interest as “payment by time
for the use of money”
– Broadly, if return is variable and linked to an
underlying return, then it is not interest (though
some exceptions)
– Also, cannot be “more than a reasonable
commercial return for the use of the principal”
(so need to define this!)
Oxford University Centre for Business Taxation
So how does tax law differentiate?
USA
Courts evaluate usually 11 to 16 factors, to evaluate
“intent”, with no fixed primacy for certain factors
• Factors include:
names of instruments; fixed maturity date or not;
fixed interest rate or not; source of repayments;
adequacy of capitalisation; ability to obtain
outside financing; extent of subordination;
whether funds used to acquire capital assets
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Is there a logical fallacy?
There may be some characteristic of debt
which initially justified different
treatment from equity
But tax law now focuses on other aspects
of debt, losing sight of initial
rationale?
Oxford University Centre for Business Taxation
Should we care? Welfare costs
• Too much debt: so greater probability of
default
• But welfare costs of higher probability of
default are hard to measure
– Very little research on welfare costs of grater
default
– Commonly thought that interest relief was not
a significant factor in financial crash
• Cost of capital could be higher or lower,
depending on how equalisation achieved
International Issues
Most countries now
• exempt foreign source dividend income
• tax foreign source interest income
So countries can choose where to be taxed!
• To be taxed abroad: finance foreign
subsidiary through equity
• To be taxed at home: finance foreign
subsidiary through debt
International Issues
• In domestic context, can question whether
to tax
– total return to investment, or
– economic rent (after deducting interest and
equivalent relief for equity finance)
• In international context, problem is worse:
– Can give relief for interest payments on debt
used to equity finance foreign activities that are
not taxed at home
– i.e. a subsidy to outbound investment
International Issues
• Surely implies some restriction is
necessary, even if difference remains:
– At a minimum limit relief to debt which does not
exceed domestic capital stock
• Or some fraction of domestic capital stock
• Many countries introducing restrictions on
interest relief through thin capitalisation
rules
– Though not necessarily well targeted
Administration and compliance
costs
Are large
• Taxpayers can exploit international
differences in definitions of debt
• Constant battle between taxpayers and
authorities
– Closing of “loopholes” leads to refinements of
instruments, and creation of new “loopholes”
Policy Questions
Is distinction sustainable?
No
• At least not without a clear and
internationally-consistent rationale
– Important to have an agreed definition of debt
(even if not theoretically justified)
Broad options:
1. Tax economic rent only
• Give relief for equity as well as debt
– Could be through ACE allowance
• Notional return on equity, defined appropriately,
can be neutral in standard models
– or give relief for total capital located
domestically, and avoid distinction entirely
• Narrower tax base
– Receive less revenue, or raise rate?
– Raising rate worsens income shifting
incentives
Broad options:
2. Tax total return to investment
• Abolish interest relief
– Like CBIT (comprehensive business income
tax)
• Would also need to consider taxation of
interest receipts
– Domestic bank loans would be unaffected if
interest received by banks not taxed
– Could limit this to interest received from
borrowers who have not received relief
Broad options:
2. Tax total return to investment
• Generates problem of taxing financial
intermediation, where profits arise from
interest rate spread
Broad options:
3. Tax part of normal return, and
economic rent
• Abolish interest relief
• Use proceeds to introduce a new relief
based on opportunity cost of all capital
– relief would not cover whole of “normal” return
– but would treat debt and equity equally
– no need for change in tax rate
Simulation Analysis of reforms
from De Mooij and Devereux (2010)
• General equilibrium model of 27 EU
countries
– designed to study impact on economies and
revenues of reforms to corporation taxes
– Models location decisions of companies,
capital, profit
– Models choice of finance
• 3 options analysed, as above
Simulation Analysis: reform in a
single country
A revenue-neutral corporation tax reform:
• ACE would require significant rise in tax rate
– Significant problem of profit shifting
• CBIT could have significant reduction in tax
rate
– Significant gain in profit shifting
• Both would reduce debt, and increase
investment at home
– But welfare falls with ACE and rises with CBIT
Simulation Analysis: co-ordinated
EU reform
Now profits shifting effects less significant,
since similar effects in all EU countries
• Again, less use of debt, with CBIT and ACE
• Investment rises with ACE, and falls with
CBIT
• Overall, welfare rises with ACE, and is left
unchanged under CBIT
Conclusions
Debt–equity divide in taxation is hard to
defend:
– it creates many of the problems of tax
administration
– legal rules are generally confused, since there
is no real principle of what characteristics are
important
– It offers ample opportunity for profit shifting
between countries
– It encourages more debt, and hence higher
probability of default
Conclusions
The best option for reform involves
international coordination, and taxing only
economic rent
If the divide is to remain, then need to coordinate internationally on definition of what
type of return receives relief