It wouldn’t be surprising if the lights are burning late these nights in the Château de la Muette, the splendid pile in Paris’s Rue André Pascal which is the headquarters of the OECD, and which was once the home of Marie-Antoinette.
Last year, the G20 organisation of the world’s richest nations asked the OECD to devise an action plan to help governments tackle companies that shift profits around the world to reduce their corporate tax obligations. The OECD delivered the first of its recommendations from its Base Erosion and Profit Shifting (BEPS) programme in September. These covered issues such as the tax challenges of the digital economy and “harmful” tax practices.
But some of the toughest work in the BEPS programme is still underway. Officials are hard at work on a proposal to limit the loss of tax from companies which claim “excessive interest deductions” against corporate debt. The move has re-opened a debate that has rumbled in the background for a number of years – whether the “tax bias” which favours debt over equity capital should be tackled in national tax codes.
Debt critics, who include former Bank of England governor Mervyn King and Lord (Adair) Turner, former chairman of the Financial Services Authority, say tax favouritism distorts investment decisions and makes debt-heavy companies a riskier prospect, especially during downturns. But David Petrie, head of corporate finance at ICAEW, and Rhiannon Jones, CBI principal tax policy adviser, believe the tax deductibility of debt interest is an essential part of Britain’s competitive business landscape.
The debate is likely to sharpen in coming months as the OECD works on the proposals in Action 4 of the BEPS programme, which is designed to limit base erosion via interest deductions and other financial payments. The normally dry-as-dust subject of tax policy could also become a contentious issue during Britain’s May 2015 general election – fuelled by news stories of multinationals allegedly dodging tax by funnelling trade through tax havens. The argument about the future tax treatment of debt tends to revolve around two central arguments.
DEBT AND EQUITY
Defenders of the status quo say it would be wrong to treat debt and equity in the same way. The rights of shareholders are fundamentally different from debt providers, says Petrie. Debt holders generally have the security of a defined return and first call on funds in the event of insolvency, but no rights to manage the business. Shareholders are taking a higher risk for which they expect a higher return. Besides, argues Petrie, there is a long history of companies using debt leverage. “Leveraging debt enables a business to expand faster and operate at a size it couldn’t if it were solely reliant on equity and retention of profits,” he says.
Critics say the preferential tax treatment of debt encourages companies to increase their leverage beyond what they would choose to do if debt was on a level playing field with equity capital. “The tax system shouldn’t go about incentivising companies to take on more leverage than they otherwise would do,” argues John Vella, a senior research fellow at the Oxford University Centre for Business Taxation.
But leverage is not a universal problem. Britain’s SMEs still find it difficult to obtain bank loans, despite government schemes such as Funding for Lending, which encourage banks to provide them. And Lord Turner has noted that publically-listed companies have reduced leverage over the years and built cash reserves.
Debt is making a big comeback in the private equity world of buy-outs, after levels sank to record lows following the credit crunch. The proportion of debt in European deals worth more than €100m (£78.16m) rose to 49% in the first half of 2014, according to the Centre for Management Buy-out Research (CMBOR). And in the bigger deals, an even larger proportion of debt may be used, says Rod Ball, deputy director of CMBOR.
No doubt these trends have been noted in the Château de la Muette. But the conundrum policymakers face is what to do about them. There is no shortage of smart policy proposals. One idea is to scrap tax deductions for debt interest except for very small firms and impose a comprehensive business income tax (CBIT). The CBIT could be levied at a lower level to compensate companies for their loss of tax deductibility.
The scheme, first proposed by the US Treasury in 1992, is popular with economists because it puts debt and equity capital on the same level playing field. But it involves such wide-ranging changes that it has never become a realistic political prospect.
Another idea, first proposed by the IFS Capital Taxes Group in 1991 and revived by the Mirrlees Review of UK taxation, is for an allowance for corporate equity (ACE).
The basic idea, as Sir James Mirrlees explained, is to provide explicit tax relief of the imputed opportunity cost of using shareholders’ funds to finance a company. But that idea falls foul of the fact that it reduces the tax base, when the main driver of governments’ policies – and the BEPS programme – is to stop tax base erosion.
Which leaves OECD policymakers with some tough thinking to do. They face a task not made easier by the fact that the BEPS programme involves 44 countries – all of which must buy into whatever solutions are proposed. Moreover, while the OECD may propose, individual countries must dispose by implementing legislation that suits their own national needs.
As a result, when it comes to the tax deductibility of debt, the OECD is likely to focus on principles rather than detailed proposals, suggests Ian Young, international tax technical manager at ICAEW. “They will want to come up with something that makes some sense to government, is a reasonable outcome for civil society and those who believe the present system is broken – and allows business to carry on doing what it does best, which is creating wealth,” he says.
But the OECD will also be taking a close look at what already seems to be working. Young points to the fact that a significant proportion of international trade takes place between related entities – where both the buyer and seller are in the same company or group of companies. “If transactions are between group companies, it may be possible to structure the arrangements so that the profit from the transaction lands up in the jurisdiction that has the lowest rate of tax,” he points out.
Similarly, if a multinational company is funding activity in a subsidiary in one country from its holding company in another, it makes sense for it to provide the capital through a loan, as interest paid by the subsidiary to the holding company will be tax deductible. Many countries have devised complex thin capitalisation rules to ensure debt finance provided in this way is treated at “arm’s length” – on terms that are not more favourable than if they were provided on a commercial basis by a third party.
Thin capitalisation rules are likely to remain significant in controlling the abusive use of tax deductibility, notes David Jervis, head of tax at law firm Eversheds. However, many countries increasingly rely on interest capping rules that put a ceiling on the level of interest which can be set against tax. Typically, interest capping rules restrict deductions on net finance costs that exceed a defined threshold such as a percentage of EBITDA, says Jervis.
Finally, some countries have developed rules which seek to redefine an interest payment as a distribution or dividend. This is particularly the case when the payment is related to business results, such as the amount of profit a company has made.
One of the problems policymakers face is that national tax authorities tend to define what they mean by debt and equity in different ways. Explains Jervis: “This presents opportunities to obtain a tax deduction for interest payable in one country but with the corresponding receipt in another country treated as an equity return and not interest, perhaps as a dividend or capital proceeds, or not taxed at all, perhaps because it is seen as an intra-company payment.” This presents multinationals with opportunities to exploit the “double non-taxation” loopholes which OECD governments hope the BEPS programme will remove.
But the problems caused by double non-taxation can only be tackled with co-ordinated international action. “I think it is perfectly possible that we will have a new global approach recommended by OECD and adopted elsewhere that will limit the amount of interest deduction that should be granted,” says Bill Dodwell, tax partner at Deloitte. But he points out that with multinationals, lenders frequently prefer to lend to the parent company’s location. As a result, it is inevitable that there will be intra-company loans as money gets passed down to subsidiaries.
Most tax specialists don’t seem to want a massive raft of new changes. “I think the rules we’ve got in this country are broadly right,” says Chris Morgan, head of tax policy at KPMG. He points out that rules such as transfer pricing and the worldwide debt cap already tame abusive use of debt for tax purposes.
Stella Amiss, corporate tax partner at PwC, says that tax deductibility of debt has been around for so long it has become ingrained in the way people do business. She points out that there has been a package of co-ordinated tax reforms over the past few years and that rules such as transfer pricing are already tightly managed by HMRC. It would be wrong to change the tax treatment of debt in isolation, she argues.
And the CBI’s Jones points out that tax deductibility was extensively reviewed during the government’s Corporate Tax Roadmap consultation in 2010. “We agree with the government’s conclusion that any changes would have potentially damaging effects on existing arrangements and could undermine the government’s commitment to providing the stability and certainty needed to promote investment and growth.”
Even so, the clamour for reform is growing. Tax campaigners have forced the issue of corporate tax on to the front pages. “The tax treatment of debt creates harmful distortions to the broader economy,” argues John Christensen, an economist who is executive director of the Tax Justice Network. “It is distorting capitalism itself. As a minimum, I would like to see a very strong capping on the amount of debt that can receive any kind of preferential tax subsidy.” Tax campaigners will seek to make the amount of tax paid by companies a political issue at next years’ general election. They noted the impact Barack Obama’s attacks on the issue had on his Republican opponent Mitt Romney in the 2012 US presidential election.
But, as Oxford University’s Vella points out, governments are caught between opposing forces – on the one hand, tax competition designed to attract business and on the other increasingly angry voters who believe that big business should be contributing a larger slice of the tax take.
Reconciling those forces is not going to be an easy task for the OECD policymakers. They are not due to publish their recommendations on suggested rules for interest deductions until September next year. So those lights are likely to be burning late in the Château de la Muette for some time to come.
Private equity investor Bridgepoint took a £150m bite out of a £375m recapitalisation of its investee company sandwich chain Pret A Manger last year.
The tasty snack was part of a growing trend for “dividend recaps” where new debt is raised partly or wholly to pay a dividend to owners. The refinancing raised Pret’s gearing from below 2x to 4.17x EBITDA.
There has been even more appetite for dividend recaps this year. Five UK companies issued corporate bonds totalling $1,348m (£826.20m) to finance dividend recaps up to mid-August, according to figures compiled by Dealogic. A further 11 companies used syndicated loans totalling $7,469m to finance dividend recaps.
One of the companies was poultry farmer Moy Park (Bondco), which raised £200m from seven-year bonds at a fixed interest rate of 6.25%. Dealogic noted Moy Park was using the money for “general corporate purposes” as well as a dividend recap.
The practice of firms using recaps to pay dividends is controversial – being likened to taking out a home mortgage and using the money to go on holiday. Companies doing a dividend recap may find their debt downgraded by ratings agencies.
Garda World Security, one of the five bond issuers identified by Dealogic, had its corporate rating downgraded by Moody’s from B1 to B2 following its dividend recap in April.
But Simon Horner, director of policy at the British Venture Capital Association, says a dividend recap can enable a firm to demonstrate a return to investors.