Introduction

From January 1 2006 - and for book years ending on December 31 2006 or later - all Belgian companies will be able to benefit from a deduction for risk capital, also referred to as a notional interest deduction.

For tax purposes, every company will be treated as if it had borrowed its own funds at a yearly interest rate equal to that of the 10-year Belgian government bond. The notional interest thus computed will be deductible from the tax base.

The purpose of this innovative provision is to restore the balance in the tax treatment of equity and borrowing as financing methods. Whereas the nominal corporate tax rate remains just below 34%, it has been calculated that the new provision will reduce the effective tax rate to an average of 26%. However, the effective rate will be considerably lower (sometimes as low as 0%) for capital-intensive activities such as financing. The new measure will therefore offer interesting tax-planning opportunities for both Belgian and foreign entities. It also provides a replacement for the successful coordination centre regime, which was enacted in 1992 but is being phased out.

Equity or Borrowing?

Tax regimes traditionally favour financing through borrowing over equity because interest payments are deducted from the corporate tax base whereas dividends are not. This disparity is unanimously considered to have been an obstacle to corporate development. The November 2004 report from the EU High-Level Group, charged with issuing proposals to implement the Lisbon Strategy, noted that company financing in Europe is over-reliant on lending at the expense of risk capital. It stated that:

"This makes it especially hard for start-ups and small and medium-sized enterprises to attract sufficient financing, as they cannot meet the demands for guarantees from traditional financial institutions."

In providing for the deduction of notional interest from the tax base, the new regime restores the balance in tax treatment by excluding from the tax base an important component of the cost of equity: the long-term interest on a risk-free debt.

New Regime

Computation of deduction for risk capital

The new legislation introduces into the Income Tax Code provisions to the effect that the tax base of any Belgian company or foreign company permanently established in Belgium will be reduced, for any given financial year, by a deduction for risk capital corresponding to an interest rate computed on the entity's total funds (ie, capital plus retained earnings as they appear on the balance sheet) at the close of the previous financial year.

The applicable interest rate will be the average rate of the 10-year government bond for the previous year, which stands at a 2005 average of approximately 3.5% - a special rule will apply to companies with an accounting year which does not end on December 31. However, the applicable rate will not fluctuate by more than 100 basis points from one year to the next: if the rate in the first year is 3.5%, the rate for the second year will be no lower than 2.5% and no higher than 4.5%. The rate is capped at 6.5%.

Certain items are to be deducted from the funds in order to prevent abuse. Special rules will apply where the company has a foreign permanent establishment in a country with which Belgium has a double taxation treaty.

Deduction of book value of shares

In order to avoid a 'cascade effect', the book value of shares in other companies will be deducted from the value of the company funds before the deduction is calculated: a share in the hands of one company represents part of the capital of another company, which itself qualifies for the deduction for risk capital. Shares not held as a fixed asset are not deducted from the computation base, as the dividend derived from them does not normally qualify for the participation exemption. This element of the tax regime provides compensation for the full taxation levied on the dividend.

Anti-abuse provision

In order to prevent companies from artificially increasing the computation base, the calculation excludes:

  • the book value of assets that (i) are held as passive investments and (ii) do not produce periodic income - this will cover assets such as paintings, jewellery, gold or undeveloped land, where these are unrelated to the business in which the company is engaged;

  • the net book value of tangible fixed assets, the cost of which unreasonably exceeds the needs of the company's activities;

  • the book value of real estate rented to, or otherwise used by, the company's directors or members of their family; and

  • reserves resulting from the mere revaluation of assets (except where the reserve has been subject to corporate income tax).

The burden of proof that an asset falls under the anti-abuse provision lies with the tax authorities.

Permanent establishment or real estate in a treaty country

Where the company has a permanent establishment or owns real estate in a country with which Belgium has a double taxation treaty, the computation base does not include the net book value of the assets and liabilities connected with that permanent establishment or real estate. This is because the income of a permanent establishment or from real estate is exempt from tax in Belgium: the cost of financing the establishment or real estate, whether by equity or borrowing, must be assessed for taxation purposes in the country where the establishment is located.

Capital increase or reduction, dividend distribution or change in excluded assets

If, during the financial year, a change occurs in the taxpayer's capital and retained earnings or in any excluded assets, this is taken into account on a pro rata basis. Such a change occurs notably where the company:

  • receives additional capital contributions;

  • repays part of its capital to its shareholders;

  • makes dividend distributions; or

  • acquires or disposes of excluded shares or assets covered by the anti-abuse provision.

Lock-up period and carry-forward of deductions

The statute currently provides that an amount equivalent to the deduction for risk capital must be entered on the balance sheet as an 'unavailable reserve' and must remain so for three years, but this condition is likely to be repealed prior to the entry into force of the regime.

If the deduction for risk capital exceeds the taxable profit for the year, the excess can be carried forward for seven years. The carry-forward of the deduction for risk capital may not be maintained in the event of a change in control of the company which is undertaken purely for fiscal purposes.

Indirect tax on capital formation

In order to promote equity financing, the act also abolished the 0.5% registration duty on capital increases and capital contributions. This change will take effect from January 1 2006.

Application

One obvious opportunity offered by the new regime is the use of a Belgian company to centralize group cash flow.

If a parent company A wants to finance the activities of a subsidiary B, A can raise the capital from a Belgian company C, which loans it to B. B then pays interest to C, which redistributes its profit as a dividend to A. The interest paid by B to C - at a typical rate of 4.1% - is taxable in Belgium, but C can offset the deduction for risk capital from the capital initially contributed by A. If the deduction rate for the year in question is 3.5%, C's taxable profit will be 0.6% of the capital amount rather than 4.1%. The standard rate of Belgian corporate income tax is almost 34%, but the actual rate paid is under 5%.

Comment

Most commentators have welcomed the new measures. It is predicted that they will be effective in attracting equity-financed investment into Belgium and will allow for a smooth transition for Belgian coordination centres.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.