65ti0030 la candia panteghini by Ignazio La Candia

Volume 65, Number 1

by La Candia, Ignazio La Candia and Paolo M. Panteghini Reprinted from Tax Notes Int’l, January 2, 2012, p. 00

Government Introduces ‘ACE’ Tax Benefit

January 2, 2012

Reprinted from Tax Notes Int’l, January 2, 2012, p. 00

Government Introduces ‘ACE’ Tax Benefit The European Commission and the IMF agree that Italian firms are more exposed to debt than other European companies and that many countries’ existing tax rules encourage excessive debt exposure by guaranteeing the (partial or total) deductibility of interest on debt, thereby creating undercapitalization and raising default risk.1 The commission and the IMF have looked at various options to eliminate this distortion. After analyzing various mechanisms to encourage self-financing in Italy, the IMF proposed the introduction of an Allowance for Corporate Equity (ACE), a tax incentive adopted by Belgium in 2005 and that is also being proposed in the United Kingdom. In line with that recommendation, the Italian government on December 5 presented a decree outlining a plan to restore a balanced budget in 2013 and to stimulate companies’ capitalization by means of a tax incentive dubbed the Aid to Economic Growth (Aiuto alla Crescita Economica). This program shares not only the acronym, but also the main characteristics, of the ACE. Under both systems, a company is entitled to deduct an allowance for equity. The allowance is calculated by applying an imputation (or notional) rate to the equity invested into the company. Under the ACE schemes, companies’ earnings are split into two components: • an imputed return on new investments financed with equity capital (the ordinary return), which is calculated by applying a nominal interest rate to equity capital; and • the residual taxable profit (profit less ordinary return).

The ordinary return, which approximates the opportunity cost of new equity capital, is tax exempt at the corporate level. Only the residual profit component is taxed at the regular corporate income tax rate.2 By ensuring the deduction of both interest expenses and the imputed income of equity capital, the ACE scheme eliminates the tax advantage of debt financing and encourages a company to retain profit or issue new equity. According to the government decree, the ACE incentive is needed to boost economic development in Italy and to aid growth by reducing the taxation of income arising from equity financing. Therefore, to enhance the capital structure of Italian companies, the Italian ACE incentive allows companies to deduct an amount equal to the notional return on new equity. According to the decree, the imputation rate is determined by the finance minister and is to be issued no later than January 31 of each year, taking into account the average financial returns of public bonds, increased by 3 percentage points. For the first three years of application, the rate is set at 3 percent. This imputation rate is applied to new equity — namely, to the upward adjustment of equity as compared with that existing at the close of the year up to December 31, 2010. The notional value of the return that exceeds the total net income declared is calculated as an increase in the amount deductible from income for subsequent tax periods. Suppose, for example, that a company’s equity is €1 million. The ACE relief would then be equal to 3 percent of equity, multiplied by the existing corporate income tax rate (27.5 percent), or €8,250. This relief could either be deducted from gross tax liability (if it exceeds €8,250) or carried forward (if it is lower). In the first year of application, the ACE base is equal to the existing equity at the end of the prior year, less the profit earned in the prior year. This starting value is increased by shareholders’ cash contributions

See European Commission (2008), Effects of Tax Systems on the Retention of Earnings and the Increase of Own Equity; and International Monetary Fund (2009), Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy.

TAX NOTES INTERNATIONAL

2 The ACE system shares some characteristics with the Italian dual income regime that was in force from 1998 to 2003.

JANUARY 2, 2012 • 1

COUNTRY DIGEST

Reprinted from Tax Notes Int’l, January 2, 2012, p. 00 The ACE regime encourages firms to increase equity, thereby reducing leverage, and as the IMF pointed out, the shift from debt financing to equity financing will reduce systemic risk.

3 Similarly, equity is reduced in the event of equity distributions, investments in subsidiaries, and purchases of companies or business units. 4 The treatment of individual firms and limited partnerships will be determined in a forthcoming ad hoc decree of the minister of economy and finance.

♦ Ignazio La Candia, Studio Pirola, Pennuto, Zei & Associati, Milan, and Paolo M. Panteghini, University of Brescia, CESifo, and AccounTax Lab

2 • JANUARY 2, 2012

Unfortunately, budget constraints have prevented the government from extending the ACE regime to all existing equity stock, so the effects of the ACE program will likely be almost negligible over the next two years. ◆

TAX NOTES INTERNATIONAL

and retained profits, with the exception of unavailable reserves (for example, due to the revaluation of a firm’s asset value).3 The ACE regime applies not only to corporations but also to individual firms and limited partnerships.4 By including these kinds of businesses, the Italian ACE regime also ensures neutrality in terms of the organizational form of a business.