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Newly Introduced Notional Interest Deduction On Capital Increase

1. Aims of the Dissertation

Recently the Belgian government has introduced a tax reform known as “notional deduction for risk capital”, the Notional Interest Deduction (NID).

“The unique deduction provides for a tax deduction for the cost of capital for both Belgian and foreign investors. It reduces the existing discrimination between the tax treatment of debt financing and the tax treatment of equity financing.” (Verhofstadt, 2006 cited in Heffes, 2006).

Under the NID, all companies subject to Belgian corporate tax will be able to deduct an amount equal to the interest they would have paid on their capital in the case of long-term debt financing. This reform will allegedly result in several positive effects:

A general reduction of the effective corporate tax rate for all companies

A higher after-tax return on investment

Encouragement of capital intensive investments in Belgium

An incentive for multinationals to examine the possibility of allocating such activities as intra-group financing, central procurement and factoring to a Belgian group entity

Continued opportunities for tax-efficient, equity-funded, inter-company financing from Belgian companies, such as the Belgian Coordination Centres, already present in the country.

Because this tax reform is new to the Belgian tax system, there is little published research about the effect on companies subject to Belgian corporate tax. Although the reform theoretically favours all companies subject to Belgian corporate tax, this dissertation will investigate the empirical capital increase effects on SMEs, more precisely for SMEs in the construction sector. To this end, the research will focus on solving following questions:

Is there a capital increase in the SMEs under investigation as a result of the NID reform?

How high is the capital increase, in nominal figures or as a percentage of last year’s equity capital mentioned in the balance sheet?

What is the primary reason for a capital increase in 2006?

The NID itself, generating a deductible cost of 3,942% on equity capital?

Capital investments resulting in the fact that the time value of tax deductions for depreciation, inventory costs and nominal financing costs is more than the tax that would be paid on income generated by a marginal investment?

Liquid investments?

Is there a correlation between the field of construction in which the SME is active (masonry, metal construction, woodwork, plastering,…) and capital increase as a result of the NID?

Is there a correlation between the scale of new capital investments and the scale of equity as a percentage of total assets for the SME’s under investigation, as a result of the NID?

2. Research Methods

The chosen methodology will be quantitative research to investigate the different research questions cited above. In light of the chosen subject, gathering numerical data is an evident course of action. This data will help the author to interpret the effects of the NID, using both descriptive and inferential statistics. The use of quantitative research methods will facilitate the examination of cause-and-effect relationships (White, 2006, p. 47). The descriptive statistics will be used to describe and compare the data, while the inferential statistics will be used to indicate whether the quantitative results of the research have arisen by chance alone or represent true differences arising from the recent tax reforms (White, 2006, pp 125-126).

The chosen research method will involve the use of a survey in the form of a questionnaire to gather information about Construction SMEs’ knowledge about and use of the NID, their capital increase following the implementation of the NID and the scale of their subsequent capital investments. The author will use a pilot survey to identify ambiguous questions and possible problems of analysis. The pilot will be sent to the construction SME clients of a befriended accountant.

Having defined the sampling frame as the Flemish construction SME sector, the sample itself could be selected using different methods. One possibility would involve systematic random sampling. The author has access to the complete Graydon database of Belgian companies, including the opportunity to make selections based on activity. Based on the size of the population, the sample could be chosen using a %sample. However, since the research method involves the use of a postal questionnaire, there is a risk of non-response bias. Therefore, the author is considering using another sampling method as well.

Assuming positive response results with the pilot, the sampling method could involve the use of accountants for the main research as well. The author works for a financial planning company that has excellent relations with over 250 accounting firms in Flanders alone. Their involvement in the research could be instrumental in raising the response rate. This could be achieved by using their support, through incorporating a covering letter in which they help to explain to their customers what the importance of the research is and how their opinion matters. The involvement of an accountant in this way can be interpreted as a variation of cluster sampling, in which the construction SME clients of each of the 250 accountants could be seen as different clusters. After a random sample of the clusters is chosen, sampling then takes place within each chosen cluster (White, 2006, p 63).

3. Feasibility

The author’s professional background as a financial planner and his current employment are helpful to this dissertation project. The available access to a vast database like Graydon and the contacts with 250 professional accounting firms are proof of that.

Discipline and good communications with the accountants (if the second sampling method is chosen) will be vital to respecting the timetable.

Access to databases for the literature review is another issue to be considered. Most of the literature on the topic of the NID has been written in Dutch, since Belgium is the only country in which these tax reform exits and they were only enacted from January 1st 2006.

The research and analysis presents less of a problem, particularly if any non-response bias can be avoided using the cluster sampling method as discussed above.

4. Relation with Existing Published Work

The introduction of the NID is a new element in the whole corporate finance and capital structure discussion that has been the subject of considerable debate in the past decades. Instrumental in this discussion is that new investments have to generate a return, which exceeds the cost of the capital component being used to fund the investment (Brigham et al, 2005, p. 307).


Capital structure theory focuses on how firms finance assets. The capital structure decision centres on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value (Groth et al, 1997, p. 553).

Traditional theory states that in general debt financing is cheaper, because (depending on the type of debt financing) the interest payments are fully or partially tax deductible costs. Consequently, the use of debt increases the value of the firm.

“The principle of the NID 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. The Bill 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.” (PWC, 2007)

Modigliani and Miller challenged these views back in 1958, stating that in perfect capital markets (including some important simplifications like the absence of taxes), the company debt policy and therefore the capital structure has no influence on the weighted average cost of capital (WACC) or the value of the firm (Modigliani and Miller, 1958, p. 268-269).

Twenty years later, Miller extended his views on the matter by stating that any situation in which the owners of corporations could increase their wealth by substituting debt for equity or vice versa would be incompatible with market equilibrium (Miller, 1977, p. 268.)

Around the same time, Jensen and Meckling argued that the owner of a company focuses on yet another equilibrium to optimize his company’s capital or ownership structure, weighing the increasing agency costs connected to reduced ownership against his desire to avoid the risk of putting all his eggs in one basket (Jensen & Meckling, 1976, p. 45).

Through empirical research, this author will examine in what way the NID could possibly challenge or support these views, given the fact that because of the NID introduction, the effective tax rate on capital is now negative at -4,4% (the effective tax rate on capital is the amount of corporate income and other capital-related taxes paid by a business as a percentage of pre-tax profits for marginal investment projects).

The deduction equals a percentage based on the return on a 10-year state bond and has been increased to 3,781% in 2007 (from 3,442 % in 2006), reflecting a light rise in interest rates. The focus on SME’s is reflected by the 0,5% advantage for that type of companies, increasing the NID to 4,281% on equity capital (BIBF, 2007).

Some authors are convinced that together with the repeal of the 0.5% registration duty on capital contribution to a company’s share capital or premium reserve as from 1 January 2006, the new measure will benefit small- to medium-sized enterprises (SMEs) and larger companies (national and international) by encouraging the strengthening of their equity (Opdebeeck, 2007). These might not be idle hopes given the fact that because of the NID Belgium has become a very appealing country for multinational companies to invest in, due to this newly acquired leading position in the lowest effective tax rate on capital. The tax rate dropped from 23,5% in 2005 to a staggering -4,4% in 2006.

Research conducted in 2006, however, shows that Belgian SME’s rely heavily on short and long term debt financing for their investments. 75% of the respondents were family owned businesses and more than 50% used both short term and long term debt financing, while only 32% used retained earnings and 29% used the capital increase funds the NID is trying to promote for the future (Laveren, 2006, p 14).

A striking figure from this research is that only 13% of all respondents experienced trouble in getting debt funding from financial institutions.

This seems to stand in contrast with other European and more distant countries, where the respective governments provide other incentives to help SME’s to get the necessary funding e.g. US policy makers have been indirect, providing funds and creating the regime conducive to the growth of the private venture capital industry. Israeli policy makers have been less indirect, taking equity positions in start-ups, and in venture capital funds in partnership with the private sector. Irish policy makers have been direct, setting up and managing start-up venture capital funds (Papadimitriou & Mourdoukoutas, 2002, p. 104).

5. Why You Are Doing This Topic

The author works for a financial planning company whose clients are predominantly CEO-owners of SMEs. An important element in the services the company renders to clients is tax planning on a company level. The size of SMEs often results in less awareness about opportunities as a result of tax reforms, because:

SMEs seldom have the means to hire personnel specialized in tax optimization.

The owner-CEO of SMEs seldom has the time to gain expertise in fields like tax planning.

The benefits of Financial Planning as a concept are not always clear to the owner-CEO of an SME.

Clear recommendations based on research and analysis about the effects of capital increase under the new NID and its effect on their bottom line can be beneficial to many owner-CEOs of SMEs. Furthermore, timely communication about these findings could prompt owner-CEOs of SMEs to take appropriate action.

As professional consultants in financial planning, the author’s company and industry stand to benefit from these gained insights, by using this knowledge to better advise clients in matters of tax planning.

In terms of the author’s MBA Modules, this is an area of research that has been the topic of much previous work, as highlighted in Section Four above and as studied in the Financial Management module. These recent tax reforms provide an opportunity to reduce or eliminate the relative advantages of debt (as compared to equity) financing, in terms of its effective after-tax cost. This research will help to determine how such opportunities have an empirical impact – which will be of interest for global policy-makers as well of those in Belgium.

6. Timing Mileposts



Due date



Stage 1: Area of interest identified



Stage 2: Specific topic selected



Stage 3: Topic refined to develop dissertation proposal



Stage 4: Proposal written and submitted




Stage 5: Collection of data and information



Stage 6: Analysis and interpretation of collected data/information



Stage 7: Writing up


Stage 8: Final draft prepared – submission of dissertation



Final Deadline: maximum nine months after starting the dissertation


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