The Tax-Induced Debt Bias in Malta – Part 3
Consequent to the arguments in favour of addressing the debt tax bias in Malta, discussed in part 2 of this article, various issues for further discussion arise, namely how the debt bias can be addressed, the extent to which it should be modified and the corrective measure to adopt.
How Can The Debt Bias Be Addressed?
Shaviro (2011) argues that not only is the tax system biased, but it favours the wrong type of financing. The European Commission (EC) (2011) has recommended that this tax-induced debt bias is addressed because of the economic distortions that it has created. Primarily, the bias incentivises high leverage for companies since it distorts financing decisions which in turn reflect in economic volatility. Secondly, it has contributed to debt and profit shifting arising from aggressive tax planning which is distorting tax bases of countries. The financial crisis has been a wake-up call, indeed, ever since then, the tax bias has ranked as one of the top priority issues in the current tax policy agenda of the European Union (EU) (EC, 2015). Many reforms in tax systems have been introduced with the intention of correcting such bias towards debt (deMooij, 2011b), such as Thin Capitalisation (TC) Rules and Allowance for Corporate Equity (ACE).
The introduction of TC rules would limit the debt bias from a corporate level because the rules cap the deduction of interest payments when they exceed a specified amount. Given that this analysis revealed that the interest deductibility influences financing decisions, then addressing the bias from a corporate perspective may help to neutralise the decisions of firms in Malta.
Findings by Fatica et al (2012) illustrate that other countries that have adopted such measures have experienced a reduction in leverage. However, tax professionals argue against the introduction of TC rules in Malta, because one of the key selling points in attracting Foreign Direct Investment (FDI) is that there are no TC rules. In fact, studies by Buettner et al. (2006) show that the introduction of TC rules reduced foreign investment in other countries.
The ACE neutralises the tax debt bias by allowing a deduction for a notional return on equity based on a risk-free nominal interest rate (de Mooij & Devereux, 2009). The ACE is praised for eliminating the tax effects on investment decisions because at a corporate level, as both the cost of debt and equity are allowed for a deduction, there are no tax distortions in financing decisions. Evidence shows that since the introduction of the ACE in Belgium in 2006, the gap of the tax differences between debt and equity has decreased, corporate leverage has reduced and FDI has increased (Zangari, 2014). In 2011, Italy introduced a system where it grants an ACE only on new capital which makes the Italian ACE a more successful measure to target the debt bias. Despite its effectiveness, the ACE only reduces tax distortions in financing strategies, and while it helped to reduce the cost of capital and equity, the debt bias in Italy is still present due to other factors that influence corporate leverage (Ceriani, 2015).
The majority of the respondents of the study find ACE as a possible measure for Malta to neutralise the tax treatment of debt and equity at corporate level while avoiding distortions in FDI. Moreover, it is believed that such a measure would encourage companies to make a public issue of equity, which is better for the profitability of companies than seeking debt finance. The deductibility of the cost of equity may also help companies to reduce their current cost of equity. A director at the Economic Policy Department (EPD) was interviewed and he heavily agreed with incentivising the use of equity as this could also trigger long term economic growth.
In addition, Webster (2012) argues that in Malta, the deduction for the cost of equity should be greater than the deduction for the cost of debt due to the over indebtedness of Maltese companies. On the other hand, while tax professionals also agree that such a system would make debt and equity on a level playing field from a corporate tax perspective, most of them fear that it would lead to more abuse of the system. A director from the Inland Revenue Department (IRD) was also interviewed and he mentioned that such a system would only be able to target the bias from a corporate perspective and not from personal tax perspective and as a result, the debt bias would still be present.
Due to the implications of an ACE, it is vital to emphasize that the majority of the interviewees believe that the Maltese investor is not fully knowledgeable about the difference between debt and equity and the risks involved. Therefore, Maltese investors are not as capable as companies and banks in managing the risks that the financial market presents. The current debt bias is pushing the companies towards debt therefore risk management rests with local firms and banks. The Director from the EPD mentioned that if the debt bias is removed and there is a shift to equity, then the risks would be shifted to the shareholders. Thus, given that the majority of Maltese investors may not have high financial literacy, moving from debt to equity would mean that risks are shifted to the less capable investors in managing such risks. On the other hand, the Director from the IRD stated that if risk is shifted to shareholders, fewer risks are faced by companies and banks which would help to reduce the high leverage of Maltese companies. This brings about more profitability for companies as they would have less debt servicing obligations.
To what extent should the bias be addressed?
A unique finding of the research is the fact that a full modification of the debt bias may result in less effective risk management for the Maltese economy. This is because the use of debt in an economy means that risk management lies with banks and companies while the use of equity may shift this risk management to individuals. As discussed, this reduction in effective risk management may result in a worse impact on the economic growth of the country. Thus, due to the danger of excessive risk shifting, the bias ought not to be fully removed.
A balance should be maintained for optimal risk management where companies, banks and shareholders take on their fair share of market risk while boosting the use of equity, lowering leverage ratios, and increasing profitability.
How can the Debt Tax Bias be addressed locally?
The full imputation system targets the bias from a personal tax perspective but this has been found to still be creating a bias. Findings show that reverting to the original full imputation system that completely eliminates one of the biases in the Income Tax Act, is not desirable due to revenue leakage. Moreover, findings revealed that the Investment Income Provisions (IIP) triggers investment since chief financial officers feel certain that public issues of bonds would provide them with the necessary investment resources.
In addition, the IIP are to some extent used to counter balance the advantage of investing in equity, that is, the potential of capital growth, with the lack of such potential in the case of debt, by providing a favourable tax rate for debt.
In this regard, and because literature criticizes measures that solve the bias from a personal tax perspective since these do not solve the issue from its corporate roots, an argument in favour of a corporate tax modification emerges. Addressing the bias from a corporate perspective is supported by findings such as the role of the interest deductibility in financing decisions and in the differences of cost of debt and equity due to taxation. Moreover, another finding illustrates that possibly less debt would be used by local companies if there were no benefit of using debt.
Having concluded that the IIP should continue to be used as an investment tool, it could therefore also serve to provide the element of bias towards debt that is required for a good balance of market risks. On the other hand, the corporate debt bias can be addressed through corrective measures and using evidence from other countries, the safest way to modify the bias would be through an ACE. The ACE is a possible measure for Malta since it not only avoids distortions in FDI and neutralises the tax treatment of debt and equity at corporate level, but also manages to boost the use of equity that is needed for further economic development.
In other countries the ACE has managed to neutralise the tax treatment of debt and equity, reduce corporate leverage and increase FDI, which are necessities for Malta. However, given that the ACE could increase abuse, it is recommended that a notional deduction for the cost of new equity only is permitted. Moreover, the deduction could be also made available for companies that decide to list their equity on the Malta Stock Exchange in order to encourage firms to list their shares. The notional deduction for equity could be determined by the Ministry of Finance in consideration to the trending bond rates. This would result in a similar deduction as allowed for debt and thus neutralise the differential tax treatment at corporate level.
Furthermore, ACE could be used as another measure alongside the full imputation system, the refund system and the various double tax treaties, as a selling point for the country. The promotion of Malta as a tax-friendly jurisdiction would be enhanced through the ACE. This could help to attract companies to set up in our country and, while benefitting from the various tax measures, they could also contribute to enhance the local economy by providing employment, generate tax revenues for the government and stimulate innovation.
In view of the above, and since evidence shows that after the introduction of tax-measures, the debt bias may still emerge, then such tax measures should be coupled with other non-tax measures. Leverage in Malta may be driven by other factors that are more important than tax, such as the culture of no dilution of ownership. As a result, non-tax measures could be implemented in parallel to the possible introduction of an ACE for good risk management. We believe that education in entrepreneurship is necessary due to the possible repercussions of the introduction of an ACE. Having assessed how the ACE could shift risks from companies towards shareholders, it is vital to ensure that shareholders become more financial literate. Moreover, risk management courses should be provided to all new investors in order to ensure a smooth transition of market risks to shareholders.
Undoubtedly, the way forward is to enhance Malta’s tax system, retaining it as one of the most tax-friendly jurisdictions not only in the EU but also around the world. The further development of the current taxation system could attract additional FDI and promote further local investment through equity that can in turn trigger long term economic growth.
A list of references is available from the editor and will be provided upon request