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
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.
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.
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
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).
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
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
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
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.
12 Source: EVCA. Back
Further information on EVCA is available online at www.evca.eu Back
The research is being conducted by the Center for Entrepreneurial
and Financial Studies (CEFS), Technische Universitat Mnchen-Germany. Back
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
Bech-Bruun (2007): "New Danish Interest Deduction Limitations
and CFC rules". Downloadable at www.bechbruun.com. Back