Canada could become more competitive economically by implementing a “notional interest deduction” that would boost equity investment, tax policy experts say. However, they concede, implementation of the innovative measure would require a complete overhaul of Canada’s corporate and personal tax system.

Belgium recently led the way by introducing the NID. Jack Mintz, business economics professor at the University of Toronto’s Rotman School of Management and fellow-in-residence at the C.D Howe Institute, calls Belgium’s move “the most significant tax reform that has been introduced this year among leading, developed countries.

“We could probably do it in Canada,” adds Mintz. However, he says, creating a low-tax environment for corporations and investment would require significant changes to the way that individuals are taxed; taxes on employment and self-employment would have to be increased.

“Taxes on labour are not unusual in Europe,” Mintz notes. He points to Scandinavian countries and the Netherlands, which already have systems in which taxes on corporations, portfolio investment income and capital gains are low, while taxes on labour are higher for individuals in the medium and high tax brackets. This is the pattern Belgium is following.

In addition to a change in the tax system, Canada would have to adopt a change in attitude. “The trouble in Canada,” says Mintz, “is that we’ve taken the view that corporations are bad and should be taxed.”

With the introduction of the NID, Belgium now has the lowest effective corporate tax rate among 36 developed countries, Mintz says. His analysis was published in September by the C.D. Howe Institute in a paper entitled The 2006 Tax Competitiveness Report: Proposals for pro-growth reform.

Mintz says Belgium’s effective corporate tax rate has fallen to minus 4.4% in 2006 from 23.5% in 2005. “That’s completely due to the NID,” Mintz says. The negative rate, he explains, reflects taxes that would be paid on income earned from a marginally profitable investment, minus deductions for items such as depreciation, inventory and financing.

The new measure is designed to eliminate the tax discrimination between debt financing and equity financing. Typically, national tax systems give companies a tax deduction for interest that they pay on loans borrowed to finance their operations. But companies that use their own equity to finance operations don’t get that break, and any dividends they pay after building their equity usually are taxed.

With the NID, Belgium wants to provide a tax break that is roughly equal to the benefit of a financing-based interest deduction and, in the process, build up equity in that country.

The measure is geared toward increasing economic activity, says Erik Sterckx, advisor general in the foreign investment division of the Belgian Ministry of the Economy. “Even Belgium’s socialist parties agreed this should be taken into account,” he adds.

Belgian government documents show that for the 2004 tax year, Belgian taxpayers paid personal taxes of 40% for income of more than 16,480 euros and 50% for income of 30,120 euros (1 euro = C$1.45). Belgians also pay a value-added tax of 6% on necessities but up to 21% on other items. The country also has an inheritance tax of 8%.

Belgium, in fact, is taking the same approach to taxation as are Sweden, Denmark and Finland, says Serge Bartholomé, head of the research department at the National Bank of Belgium, who proudly displays a copy of Mintz’s report in his Brussels office.

“These countries have social contracts with better economies. We’re not inclined to follow the British model,” Bartholomé says, “in which individual taxes may be low, but so is the interest the state takes in individuals.”

This attitude is supported by the Belgian private sector: Belgians are hoping the NID will result in a stronger economy. Belgium has a top-notch health-care system, says Jane Murphy, a Quebec-born lawyer practicing with Lawfort, a Brussels-based international corporate law firm associated with Toronto law firm Cassels Brock & Blackwell LLP: “Compared to Canada’s, it’s a limo.”

A large portion of the personal taxes collected in Belgium go toward maintaining a strong social security system. Higher taxes preserve the Belgian middle class, avoid conflict and create a stable country for doing business, says Lawfort managing partner Marc Vandemeulebroeke.

Mintz says the NID should result in stronger corporations and a healthier economy. With corporations borrowing less to finance their operations, the potential for bankruptcies decreases, he says.

@page_break@One example for using the deduction would be a multinational corporation that bases a back-office subsidiary in Belgium to handle intragroup financing and procurement, says Alexandre De Geest, advisor to Belgium’s minister of finance, Didier Reynders. This type of company needs a lot of capital to operate and, as a result, is equity-intensive.

However, the new measure is directed not just at multinationals. All companies with operations in Belgium — resident and non-resident, large and small — can utilize the NID. “A company can optimize how it is used within its corporate structure,” says Bart Adams, international tax expert with the fiscal department for foreign investments in the Belgian Ministry of Finance.

The deduction is calculated by multiplying “qualifying equity” by the deduction rate. The rate is to be set annually based on the Belgian 10-year bond rate. This year that rate is 3.442%. (Small and medium-sized enterprises are entitled to an upgrade of 0.5%, to 3.942%.)

As long as the company’s return on equity is equal to or lower than the deduction, no corporate taxes will be paid, says Adams.

Under Belgian accounting rules, equity includes capital, share premiums, reserves, carry-forward profits or losses, and capital investment subsidies. However, for the purpose of calculating the NID, certain amounts are deducted. These include:

> the fiscal net value of company shares that the company (as opposed to investors) holds in the company;

> the fiscal net value of shares issued by investment companies (which are prohibited from applying for the NID, denying them a second crack at the tax break already received by a company);

> net equity value assigned to real estate;

> capital grants and subsidies.

The dark side of the deduction is that it could set off a race to the bottom that would leave national tax coffers empty.

If Belgium is the one EU country to adopt this measure, it might be tolerated, says David Perry, senior researcher with the Toronto-based Canadian Tax Foundation. But if Canada adopted a measure similar to Belgium’s NID and the U.S. did not, he says, the Americans probably would accuse Canada of acting in a predatory manner.

However, Mintz notes, corporate tax rates are decreasing worldwide. Among member nations of the Organization for Economic Co-operation and Development, the average corporate tax rate has dropped to 28% from 48% in 1980.

Meanwhile, he adds, there has been a significant shift to other taxes, such as sales taxes and user fees, broadening national tax bases: “Total taxes as a ratio of GDP have been increasing.”

Some reasons for this shift are purely pragmatic. It’s getting harder to tax corporations with their increasing ability to “shift profits without moving a person or machine,” says Mintz.

And some countries — such as Belgium — are also cutting corporate taxes because they don’t want to lose the corporations.

Dealing with the impact of this shift requires rethinking individual tax benefits such as tax credits, says Mintz.

If companies pay few taxes, Perry says, it doesn’t make much sense to give individuals a tax credit for corporate profits they receive in the form of dividends. The credit is now given to individuals so the same corporate profit won’t be taxed twice, he notes.

Both Mintz and Perry say a country considering lower corporate taxes should rebalance how individuals are taxed in order to avoid an economy driven by tax planning. Taxes should not discriminate between income from interest, dividends or capital gains.

Notably, that’s not the case in Belgium, where individuals do not pay any taxes on capital gains but pay 15% on interest income and 25% on dividends.

“Canada is more diligent about balancing our personal and corporate income taxes,” says Perry. “Belgium doesn’t worry about it. We do. We have a system that works reasonably well.”

However, says Mintz, the increased economic competitiveness behind a tax system that fosters investment while maintaining higher taxes on labour should be considered in Canada: “It’s worth some study. We could see whether we want to go in that direction.” IE



Stewart Lewis, senior reporter and tax columnist for Investment Executive, went to Brussels in October to examine the impact of the notional interest deduction.



FOR MORE INFORMATION ON THE NID,
SEE STORY ON PAGE 26