How Notional Interest Deduction Can Add Value to the Treasury Function in Belgium

Particular European countries have a strong tradition as treasury locations, such as Switzerland, Luxembourg and Ireland. Belgium also forms part of this shortlist, as it recently amended its domestic tax rules to boost its tax attractiveness for treasurers.

With the Law of 22 June 2005, the Belgian government introduced a notional interest tax deduction for risk capital¹. The legislation governing notional interest deduction came into force from assessment year 2007, i.e. for financial years ending on or after 31 December 2006.

This innovative amendment in Belgian tax law allows Belgian tax-resident companies and Belgian branches of non-resident companies to claim a tax deduction for the cost of capital. It allows them to deduct notional interest at a rate calculated on the aggregate amount of their equity including retained earnings.

According to the explanatory notes to the Law, this concept was added to Belgian tax law to promote the Belgian economy by reducing costs for companies active within the Belgian market. Indeed, economic players have the choice of whether to finance their activities through debt-financing or equity-financing. Under Belgian tax law, interest expenses are generally fully tax-deductible, e.g. a 7/1 thin capitalisation rule only applies in very specific circumstances, while dividends are part of the distributing company’s taxable basis. Hence there is non-justified economic discrimination between companies that appeal on equity-financing compared with those appealing on debt-financing. The purpose of the notional interest deduction 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 analysing the return investors require when buying a share. Their requirement can be estimated using such tools as the capital asset pricing model (CAPM). The underlying premise of the approach is that the greater the risk taken on by an investor, the higher the rate of return expected. Risk-premium model rely on the assumption that each individual holding a risky security will demand a return in excess of the return they would expect from a risk-free security. This excess return is the premium to compensate the investor for risk that cannot be diversified.

The notional interest deduction aims to recognise the risk-free interest component by considering it a tax-deductible item. Hence, an equal treatment of equity-financing and debt-financing can be assured while ensuring that the company at hand will only be taxed on 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 they have a high solvency ratio and should therefore be protected against the bankruptcy risk.

An EU-compliant Solution for the Belgian Coordination Centre Regime

This innovative measure should be a solution for Belgian Coordination Centres whose licences will lapse by 31 December 2010. Belgian Coordination Centres have, for many years, been a successful way of attracting multinationals to centralise shared functions in Belgium (including finance) on a pan-European basis. Indeed, for over 20 years, Belgium has built up an international reputation as tax-attractive location for finance centres thanks to the know-how and presence of such Coordination Centres. However, due to developments within the EU tax scene, the Belgian Coordination Centre regime is destined to disappear by 31 December 2010.

The notional interest deduction is considered compliant with EU ‘state aid’ rules, as it is accessible to all Belgian tax-resident companies and Belgian branches of non-resident companies, irrespective of their activities. Only in a limited number of cases will the deduction not be available, i.e. in circumstances where the taxpayers are subject to a Belgian tax regime that deviates from the common Belgian tax regime.

Indeed, the EU commissioner Neelie Kroes confirmed on 21 March 2007 that the entry into force on 1 January 2006 of the ‘notional interest deduction’ scheme seems to offer (coordination) centres a genuine alternative.

Main Features of the Notional Interest Deduction Regime

Under the new rules, a sui generis corporate tax deduction has been introduced, i.e. Belgian corporate income taxpayers are, for tax purposes, allowed to claim a notional interest deduction reflecting the economic cost of capital use, equal to the cost of long-term, risk-free financing.

Reference is made to the annual average of the monthly rate paid on 10-year Belgian government bonds, which amounted to 3.442% for assessment year 2007 and amounts to 3.781% for assessment year 2008. The Belgium government has confirmed that the introduction of the notional interest deduction generally results in a decrease in the 33.99% standard corporate tax rate to approximately 26%, without any further planning. To illustrate the impact of the notional interest deduction, we consider the following example:

As you can derive from the table, thanks to the mere impact of the notional interest deduction, and hence without further planning, the company’s effective tax rate drops from 33.99% to 2.5%.

Note that from one year to another, the notional interest deduction rate cannot deviate more than 1% from the previous rate, with a ceiling of 6.5%. Nevertheless, in line with a Royal Decree, it will be possible to not apply this limitation and instead define another rate.

In case of so-called high-yield financing, further tax planning allows an attractive effective tax rate. It should be noted that, in addition to the notional interest deduction, actual ‘at arm’s length’ interest expenses remain tax deductible. Such interest expenses do not generally attract Belgium interest-withholding tax if attributed to or made payable by a genuine Belgium finance centre rendering inter-company financial services only.

Small and medium-sized corporates, as defined for Belgian company law purposes, are allowed to raise the reference interest rate by 0.5%.

Notional interest deduction is calculated based on the company’s share capital plus its retained earnings, as determined for Belgian GAAP purposes (as per the last year-end date). Hence, companies who have the legal option not to file annual accounts will have to waive this option if they want to claim a notional interest deduction.

Obviously, for a newly incorporated company, no last year-end date is available, thus, the starting point for the computation of the notional interest deduction is the company’s equity on the date of incorporation. For financial years of more or less than 12 months, the reference interest rate is multiplied with the number of days of such a financial year and divided by 365.

Certain adjustments to this reference interest rate used should also be made. For example, the accounting equity as of the last year-end date must be reduced by the following items (all valued at the same year-end date):

• The fiscal net value of own shares held by the company.
• The fiscal net value of financial fixed assets qualifying as ‘participations and other shares’.
• The fiscal net value of so-called Equity-UCITS, i.e. investment companies whose dividends are eligible for the Belgian participation exemption, i.e. qualifying dividend income is 95% tax-free for a Belgium corporate shareholder.
• If the company has foreign permanent establishments (PE), the positive difference between the net book value of assets – other than the above shares which are already excluded from the equity – attributable to the foreign PE and the liabilities – other than equity – attributable to the PE.
• If the company has real estate (rights) abroad – which is not yet excluded because attributable to a PE – whose income is tax-exempt in Belgium due to tax treaty protection, the positive difference between the net book value of that real estate and the liabilities – other than equity – attributable thereto.
• The net book value of tangible fixed assets whose corresponding costs unreasonably exceed the needs of the company.
• The book value of any other investment that is not acquired in order to produce a regular income.
• The book value of real estate (rights) used/occupied by either individuals having a director or liquidator mandate in the company or by their spouse or dependent children.
• Revaluation gains in respect of assets, other than the aforementioned assets, and capital subsidies.

In conclusion, most of these adjustments are aimed at:

• Avoiding duplicate usage, as dividends and capital gains derived from shares are generally already eligible for the participation exemption whereas profit of a tax treaty PE and real estate located in tax treaty countries are tax-exempt in Belgium.
• Avoiding abuse, as taxpayers may be tempted to artificially blow up a company’s equity to maximise the notional interest deduction, e.g. by contributing ‘private’ assets such as art or jewels.

For the sake of accounting reality, components of the accounting equity are adjusted upwards or downwards on a prorate basis in case they change during the financial year. Changes are deemed to have taken place as of the first day of the calendar month following the month in which the change took place. Specifically, every change is multiplied by the number of calendar months still to come and divided by the number of months of the financial year at hand. Needless to say, the purpose here is also to deceive artificial changes in equity capital to ‘manipulate’ the notional interest deduction.

The non-utilised part of the notional interest deduction can be carried forward for a maximum of seven years if there is insufficient tax capacity in the year the deduction is claimed. From a tax-technical viewpoint, the deduction will be claimed prior to offsetting carry-forward tax losses, if any, in the tax return. In case of a purely tax-driven change of control of a company with carry-forward notional interest deduction, the latter will forfeit.

No (advance) ruling is required for claiming the deduction. Nevertheless, the taxpayer has the option of filing a ruling request in specific cases. Our experience shows that, although there is no obligation to file such a request in order to benefit from the notional interest deduction, some taxpayers nonetheless opt to do so for particular transactions. It is also possible to arrange an informal anonymous pre-filing meeting with the Belgium ruling commission without any obligation to file a ruling request afterwards. Such meetings have proved to be very powerful tools for gauging the initial feedback of the ruling commission with regards to specific theoretical transactions. Belgium tax rulings are valid for five years, but can be renewed.

Belgian Capital Duty at 0% to Promote Equity-financing

The Belgian Government has abolished the 0.5% proportional capital duty for capital increases and capital contributions as of 1 January 2006 to encourage equity-investments. These capital contributions and increases now attract a fixed duty of EUR 25 that – as is the case for notary fees – is generally deductible for Belgian corporate tax purposes.

In doing this, the Government wants to make sure that, in addition to its tax-attractive holding company regime – e.g. no CFC and no minimum detention period condition for eligible realised capital gains on shares to be 100% tax-exempt in Belgium. Belgium has a competitive capital duty tax regime compared to other traditional holding company locations in Europe.

What Notional Interest Deduction Means for Treasurers

The above clearly demonstrates why Belgium should be on a group tax manager’s radar screen when considering international tax planning. In addition to Belgium’s central location within Europe and its tax-attractive holding company, ruling practice and expatriate tax regime, the notional interest deduction will further enhance the Belgium’s tax profile in an international tax context for all types of industries. Specifically:

• The measure provides a smooth transition for existing Belgian Coordination Centers whose rulings lapse within the next few years.
• The measure attracts new group financing vehicles as it allows for an EU-proof, financing structure, whereby equity is injected capital-duty-free into a ‘common’ Belgian company by a group (EU intermediary) holding company to leverage other operating companies or to render (either low or high risk) servicing activities to (related or unrelated) companies.
• The measure is also attractive for new equity-maximised investments into Europe in general.

In this respect, it is important to underpin, as the Belgium Minister of Finance has already confirmed on two occasions, that there is no budgetary reason to amend the notional interest deduction legislation at short notice, e.g. by adding anti-abuse legislation.

Finally, the Belgian Minister of Finance recently confirmed that the notional interest deduction can be (partially) waived in case a higher effective tax rate would be needed in Belgium e.g. for the purpose to satisfy a foreign parent company, CFC or the participation relief test.

How to Add Value

In the example below, we illustrate briefly where notional interest deduction can add value to the business of a treasury function:

• A corporate tax deduction is achieved for the borrowing subsidiaries as regards fair market interest paid to the Belgium financing centre.
• Pursuant to the implementation of the EU Interest & Royalty Directive (or based on other tax legislation or tax treaties), there is generally no interest withholding tax at source.
• In the event that there would be interest withholding tax at source, a Foreign Tax Credit is available in Belgium if conditions are satisfied.
• The notional interest deduction is available in Belgium with regard to at arm’s length (interest and other) income received.
• Actual at arm’s length interest expenses, if any, can be offset against at arm’s length interest (and other) income exceeding the notional interest deduction rate of the Belgium financing centre.
• There is no Belgium dividend withholding tax for dividends paid to a tax treaty parent if the latter holds at least 15% of the Belgium shares for at least one year.
• The tax attractive Belgium holding regime provides for a 95% participation exemption on qualifying dividend income and for a 100% participation exemption on qualifying realized net capital gains on shares. Note that a genuine Belgium holding generally has a 0% effective tax rate.
• The Belgium expatriate tax regime and the Social Security Totalisation Agreement concluded with, for example, the US and Japan allows a very competitive overall payroll charge in Belgium, which is helpful in providing the appropriate level of skilled substance in Belgium.

Conclusion

The Belgian notional interest deduction regime above is a recent example of the European/global race among jurisdictions to attract global treasury functions… a race that is surely a long way from being over.