Select Committee on Treasury Written Evidence

Memorandum from the EVCA


  Further to its previous submission to the first call for evidence by the Treasury Select Committee on 9 May this year, EVCA, The European Private Equity and Venture Capital Association, would like to thank the Treasury Select Committee for the opportunity to provide additional evidence in relation to its enquiry into private equity, and again help frame analysis within the wider European context.

  EVCA was established in 1983 and is based in Brussels. It represents the European private equity and venture capital (PE/VC) industry and promotes the asset class within Europe and throughout the world. Its role includes representing the interests of the industry to regulators and standard setters; developing professional standards; providing industry research; professional development and forums, facilitating interaction between its members and key industry participants including institutional investors, entrepreneurs, policymakers and academics.

  EVCA's 1,200 members represent over 80% of PE/VC capital under management in Europe.[12] Its members represent all main industry stakeholders, from PE/VC fund management companies to institutional investors (banks, pension funds, insurance companies, family offices ...), to professional advisors (lawyers, placement agents, investment bankers|) and national (European) trade associations.[13]


  As the Treasury Select Committee has asked for respondents to provide comments on a number of specific issues, EVCA would like to focus its comments on the tax treatment of debt, and to draw the attention of the Treasury Select Committee to a number of recent developments in different Member States within the European Union (EU).

  In 2007, several EU countries adopted new taxation rules aiming at restricting interest deductions in corporate tax systems. EVCA will publish a paper[14] on the impact of such developments on investment decisions and capital markets early in 2008. Although the research being undertaken is not yet fully complete, EVCA considers it important to share some of its preliminary findings with the Treasury Select Committee.

  Thin capitalization rules have been in effect in some EU Member States for a relatively long period of time. These rules qualify interest payments on related-party debt as hidden dividends in order to prevent dominant shareholders from exploiting the differential tax treatment of debt as opposed to equity. More recently, several Member States (Denmark, Germany and Italy) have implemented so-called `interest stripping' rules. Such rules consider high debt ratios as being a tax abuse and aim to limit the level of related and non-related party debt.

  Interest stripping rules can be considered as a reinforcement of thin capitalization rules. Such an evolution appears worrying in the light of the research conducted by Buettner et al (2006).[15] This demonstrates that thin capitalization rules negatively impact the investment activity of companies. Therefore, interest stripping rules should be analyzed for their wider impact on the economy, and not just on a sectoral or industry specific basis. Moreover, another dimension should also be taken into account, namely the impact of such rules on the functioning of the European internal market.


    —  The first obvious drawback of the implementation of such rules is a reduction in investment activity by companies. This can be demonstrated as follows:

    —  The after-corporate-tax weighted average cost of capital (WACC) of companies is defined as WACC=kew+kd(1-Tc)(1-w), where w is the share of capital financed by equity, ke is the investor's required return on equity, and kd is the investor's required return on debt, before personal taxes. When interest expenses are not fully deductible from the corporate tax base, the formula changes to WACC=kew+kd(1-Tc(1-θ))(1-w). To the extent that the pre-personal-tax cost of debt, ie kd, is unchanged, the WACC of the firm increases for any θ being positive. Consequently, companies will reduce their investment activities as projects that had a positive net present value before the introduction of the interest stripping rule may turn out to have a negative net present value under the increased WACC.

    —  A second important drawback is that interest stripping rules have an asymmetric pro-cyclical effect. During macro-economic slowdowns, companies suffering from liquidity constraints would see their situation worsened as a result of taxing earnings before interest due. Indeed, interest stripping rules could result in companies being taxed although their earnings after interest could be negative.

    —  Thirdly, such interest stripping rules could potentially reduce the value of corporate loans held by institutions such as banks, insurance companies, and pension funds. Such an evolution would not only negatively impact investment, but also overall consumption and saving decisions, thus ultimately depressing and reducing economic growth.

  In the current macro-economic context, the implementation of tax mechanisms that could reinforce economic crises seem inappropriate. The risks presented above suggest that EU Members States who have implemented such interest stripping rules have first carefully conducted a cost/benefit analysis of such measures. However, the benefits usually presented by such authorities only relate to preventing a decrease in tax revenues. This argument is questionable, as for the last 30 years corporate tax revenues have increased in the majority of OECD countries. Moreover, in the case of Denmark, the interest stripping rule was introduced as the government expected a decrease in taxes and duties resulting from the effect of leverage on companies of just 0.2% of the total amount due for collection in 2007[16]. Consequently, the benefits of interest stripping rules seem to bear no proportion to their both real and potentially negative costs to the wider economy.


  The interest stripping rules that have been implemented in some EU Member States move part of the tax base generated by interest income from the country of residence of the investor to the country of residence of the company. Consequently, the flow of corporate loans across the European internal market could be significantly distorted. Further research should be undertaken in this area to fully understand the impact of interest stripping rules on the well functioning of the internal market.


  It appears that the recent developments regarding the tax treatment of interest expenses are a source of serious concern in respect of unintended consequences due to:

    —  Their potential negative impact on economic growth and the future competitiveness of EU Member States who adopt restrictive measures, as well as for the European Union at large.

    —  The inappropriateness of some tax measures that could reinforce macro-economic crises.

    —  The potential constraints on the free movement of capital across the European Union.

  EVCA will be pleased to share the final results of its research on the impact of restricting interest deductions in corporate tax systems on investment decisions and capital markets with the Treasury Select Committee and other stakeholders such as the European Commission upon its completion and publication, which is scheduled for early 2008.

December 2007

12   Source: EVCA. Back

13   Further information on EVCA is available online at Back

14   The research is being conducted by the Center for Entrepreneurial and Financial Studies (CEFS), Technische Universita­t Mnchen-Germany. Back

15   Buettner T-Overesch M-Schreiber U-Wamser G (2006): "The impact of thin-capitalization rules on multinationals' financing and investment decisions", Working Paper No 06-67, ZEW. Back

16   Bech-Bruun (2007): "New Danish Interest Deduction Limitations and CFC rules". Downloadable at Back

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