Debt in the firing line

June 28, 2010

The financial crisis has caused some policy-makers to question whether the tax deductibility of interest on debt creates dangerous economic distortions.

Debt is a double-edged sword. Used wisely, it can fund investment and growth, and boost returns for shareholders. But as the global financial crisis has shown, excessive leverage in the system can have disastrous consequences. As a result, leverage ratios in financial institutions are now an important topic of discussion for policy-makers.

But an area that has received less attention is the different tax treatment of debt and equity, and the extent to which this played a role in fuelling the crisis.

In the run-up to the crisis, many of the world’s leading banks increased their leverage ratios dramatically as they funded balance sheet expansion through higher levels of debt.

Over the same period, private equity firms embarked on increasingly ambitious deals. According to the International Monetary Fund, the funds raised by private equity firms between 2003 and 2005 increased fivefold to approximately US$230bn. Many corporates also increased levels of debt on their balance sheets as they came under pressure from investors to generate private equity-like returns.

All things being equal, it should make little difference whether companies fund themselves by means of equity or debt. But all things are not equal – indeed, the tax treatment of debt is more favorable than equity because the interest paid on debt is tax-deductible, while dividends on equity are taxed.

“The tax effect creates a distortion in the financing choices for companies,” says Meziane Lasfer, Professor of Finance at Cass Business School.

The IMF argues that this distortion was a contributing factor to the crisis. In a June 2009 paper, it noted that most tax systems have strong incentives for corporations to use debt rather than equity finance.

It also alleged that biases in the tax system encouraged financial institutions to construct complex financial instruments and structures. “Tax distortions are likely to have contributed to the crisis by leading to levels of debt higher than would otherwise have been the case,” say the authors.

During good times, high levels of debt can help to boost financial returns. This was particularly true during the recent credit boom, when the cost of debt was low and its availability high. The beneficial tax treatment added to the attraction of gearing up balance sheets.

“When the economy is performing well, higher levels of debt lead to higher profits for shareholders because the debt has stayed at a fixed interest rate,” says Prof. Lasfer. “But in a downturn, highly leveraged companies are much more likely to suffer and will tend to reduce their debt levels by swapping debt for equity, or paying back their debt using existing internal cash flow, or new cash generating strategies such as raising equity capital, asset sales or restructuring.”

In the financial sector, the proposed Basel 3 rules will force banks to increase their capital and liquidity buffers, and thereby bring down their leverage ratios. “There are lots of regulatory drivers towards having more equity capital in your business rather than debt capital,” says Christopher Price, Head of Tax for Ernst & Young’s EMEIA Financial Services Tax Practice.

Until recently, the issue of tax deductibility on interest attracted only limited attention among policy-makers. But the debate could be about to get more heated.

“There is a discussion emerging on whether policy-makers should remove some of the attractiveness of debt as opposed to equity from a tax perspective,” says Mr Price. “Policy-makers are starting to ask whether it is right for companies to get a tax deduction for interest, but not a tax deduction for dividends. They want to understand whether the differing tax treatment has an excessive influence on companies’ decision to increase their levels of debt.”

Broadly speaking, there are two options that governments can consider to achieve a more neutral position on the tax treatment of debt. The first is to provide tax allowances for dividends and capital gains to bring the position more in line with interest.

Until 1997, there was a similar treatment of dividends in the UK under the advance corporation tax regime, which allowed shareholders to assume that basic rate income tax had been paid on any dividends they received.

In 2005, Belgium introduced a similar measure, called Notional Interest Deduction, which enables companies to deduct a fictitious interest cost on equity from their tax base. The problem with this approach is that it reduces the tax base and may require governments to raise headline rates of corporation tax in order to compensate for the loss in revenues.

The second option is to remove the tax deductibility of interest and bring it into line with the treatment of dividends. One advantage of this approach is that it would raise tax revenues and give administrations the option to reduce headline corporate rates. A report from Policy Exchange, a UK-based think tank, estimates that if taxation on debt interest raised £15.5bn for the UK tax authorities, then the corporation tax rate could be cut by 11%, from 28% to 17%.

But there are disadvantages with removing interest deductibility, too. There would be strong opposition to such a move from powerful business lobbies, such as the private equity industry, which have a vested interest in maintaining the current tax treatment of debt.

“Any change in the deductibility of interest would be a real hammer blow to the private equity model,” says Price. “It requires this treatment under the economics of its transactions.”

And it is not only the private equity industry that would feel the pinch. Many corporates have built their capital structures on the assumption that tax will be deductible on interest, and an abrupt change in the rules could have a significant impact on their balance sheet.

Moreover, the revenues raised by eliminating the tax deductibility of interest could easily be offset by the loss of companies that decide to move to a tax environment that is more favorable to their business model.

“The rumours that the tax treatment of debt could be overhauled and restricted could have severe and unintended consequences and should not be rushed as a piecemeal amendment,” says Michael Wistow, head of tax at Berwin Leighton Paisner. “The tax system needs to be coherent, globally competitive, clear and predictable and any major change should be subject to consultation and an impact assessment.”

Major changes to the tax treatment of interest may not be imminent, but there are powerful voices arguing for a shift towards a more neutral position. As corporates turn their attention to growth strategies, as the private equity industry ponders its future, and as banks determine a more prudent approach to leverage, the issue is another layer of uncertainty with which the business world must now contend.