Michael P. Devereux

The Future of Business TaxationErasmus University

June 11, 2010

THE TAX TREATMENT OF DEBT AND EQUITY

Michael P. Devereux

Oxford University Centre for Business Taxation

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?


Two Starting PointsComprehensive 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


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


HybridsAny 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


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?


Why? One possible reasonOne 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?


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


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


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)


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?


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


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!)


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


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?

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


• 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


• 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 reformsfrom 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 co-ordinate internationally on definition of what type of return receives relief

Documents

Michael P. Devereux