These innovative measures will amend Belgian tax law so that all Belgian tax-resident companies and Belgian branches of non-resident companies can claim a tax deduction for their cost of capital by allowing them to deduct notional interest at a rate calculated on the aggregate amount of their equity including retained earnings.
This concept will be added to Belgian tax law to promote the Belgian economy by reducing costs of companies active on the Belgian market. Indeed, economic players have the choice to finance their activities either through debt-financing or through equity-financing. Specifically, under Belgian tax law, at arm’s length interest expenses are generally fully tax-deductible – e.g. a 7/1 thin capitalization rule only applies in very specific circumstances – while dividends are part of the distributing company’s taxable basis. Hence, there is a non-justified economic discrimination between companies that appeal on equity-financing compared to those appealing on debt-financing. The purpose is to put an end to such discrimination by allowing a notional interest deduction in case of equity-financing.
The principle of the notional interest deduction is based on the traditional financial theory demonstrating that it is relatively easy to isolate a risk-free interest rate component embedded in a return on risk capital. Indeed, modern financial theory suggests that the cost of equity can be estimated from analyzing what return investors require when buying a share. Their requirement can e.g. be estimated using the Capital Asset Pricing Model, known as CAPM. The underlying premise of the approach is the more risk an investor is required to take on, the higher the rate of return that will be expected. It is a class of market models called risk-premium models that rely on the assumption that every individual holding a risky security will demand a return in excess of the return they would receive from a risk-free security. This excess return is the premium to compensate the investor for risk that cannot be diversified anyway.
The law aims at recognizing the risk-free interest component by considering it a tax-deductible item. Hence, an equal treatment between equity-financing and debt-financing can be assured while it is safeguarded that the company at hand will only be taxed on its actual business profit.
Finally, a notional interest deduction will give companies an incentive to finance their investments through equity and therefore to strengthen their capital structure. In the eyes of the government, capital-intensive companies should by all means be encouraged as they are the engine of the economy and hence play a key role in further developing the Belgian economy. Such companies make a lot of investments and employ numerous people implying that, by nature, they have a high solvency ratio and should therefore be protected against the bankruptcy risk.
In addition, this innovative measure should be a solution for Belgian Coordination Centres whose licences lapse as of 31 December 2005. According to the answer of the Belgian Minister of Finance to a parliamentary question, approximately 88 Belgian Coordination Centres will see their licence expire on 31 December 2005.
Key Features of the New Rules
Companies liable to Belgian corporation tax (including Belgian branches of foreign companies) are to be granted a notional interest deduction equal to the 10 year OLO rate (to be fixed at year end but likely to be around 3.5 per cent) on the equity shown in the company’s individual Belgian financial statement. This equity needs to be slightly altered, and e.g. holdings in subsidiary companies (inter alia) are to be trimmed off in assessing the relevant equity figure. To the extent that the interest deduction does not have a direct tax effect (e.g. in loss situations), the interest deduction can be carried forward for the next seven years.
Uses of the New Rules
The uses of the new rules can be outlined by means of the following cases:
Equity funding of the Belgian subsidiary by its foreign parent (equity = 100). If, in this case, the Belgian subsidiary achieves a return on equity of 10 per cent, the corresponding profit (here, 10) is subject to the standard Belgian rate of tax of 33.99 per cent. As a result of the notional interest deduction, the effective tax charge falls to 22 per cent. Accordingly, Belgian investments are effectively taxed as they are in Eastern European, low-tax jurisdictions (Czech Republic: 24 per cent; Poland: 19 per cent), since the interest deduction results in a lowering of the effective Belgian corporation tax rate.
The advantage of the notional interest deduction over low rates of tax on profits is that, as a result of the deduction being made from the tax basis, the Belgian tax can drop to nil where the company’s return on equity is less than or equal to 3.5 per cent. In this event, because of the notional interest deduction, no Belgian corporation tax is due.
Rather than a Belgian subsidiary taking out external refinancing from a bank, the foreign parent company could take out a bank loan and forward the monies raised to its Belgian subsidiary as equity. As a result of this, a double interest deduction is achieved (double-dipping): the bank interest paid by the foreign parent reduces its domestic tax basis and additionally the tax basis in Belgium drops by reason of the notional interest deduction.
Where the parent company currently funds its Belgian subsidiary by means of shareholder loans, consideration should be given to whether the shareholder loan should not be repaid and replaced by a capital contribution. Restructuring of assets within the group: the notional interest deduction can potentially be optimized by means of a contribution of assets (from Belgian or non-Belgian group companies) whose transfer does not represent taxable profit (in practice, working capital items particularly) to the capital of an existing or newly incorporated Belgian company.
Example
To illustrate, consider the following example:
| B/S | |
| Asset 100 | Equity 100 |
| With notional interest deduction | Without notional interest deduction | |
|---|---|---|
| Tax profit: | 4 | 4 |
| Notional interest deduction: | (3.5) | (0) |
| Effective tax basis | 0.5 | 4 |
| 33,99 per cent corporate tax | 0.1 | 1.4 |
| Effective tax rate | 2.5 per cent | 33.99 per cent |
What Do You Have to Do?
The notional interest deduction is not a special tax regime that needs to be applied for. Nonetheless, the following measures should be undertaken in order to take best advantage of the new rules:
- An analysis of the capital structure of Belgian (group) companies;
- A review of the group structure;
- An examination of the equity, since some items qualify for the interest deduction, but others do not;
- A review of the current assets of the Belgian and non-Belgian group companies;
- A review of whether it is opportune to set up a group financing company/branch in Belgium or, possibly, a review of whether it is worth restructuring the activities of the Belgian BCC company, if applicable;
- In certain circumstances, a review of the business model, in order to avoid risks of a tax charge under CFC rules, if any.
Since the basis of the notional interest deduction for 2006 will be the accounting capital on 31 December 2005 (for companies whose accounting period runs to 31 December), steps to optimize the notional interest deduction should be taken into consideration as quickly as possible.