The effect of notional interest deduction on the financing policy of SMEs

Transcription

1 UNIVERSITEIT GENT FACULTEIT ECONOMIE EN BEDRIJFSKUNDE ACADEMIEJAAR The effect of notional interest deduction on the financing policy of SMEs Masterproef voorgedragen tot het bekomen van de graad van Master in de Toegepaste Economische Wetenschappen Sofie Cornelis Steffie Merckx onder leiding van Prof. Dr. Philippe Van Cauwenberge

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3 UNIVERSITEIT GENT FACULTEIT ECONOMIE EN BEDRIJFSKUNDE ACADEMIEJAAR The effect of notional interest deduction on the financing policy of SMEs Masterproef voorgedragen tot het bekomen van de graad van Master in de Toegepaste Economische Wetenschappen Sofie Cornelis Steffie Merckx onder leiding van Prof. Dr. Philippe Van Cauwenberge

4 PERMISSION Ondergetekenden verklaren dat de inhoud van deze masterproef mag geraadpleegd en/of gereproduceerd worden, mits bronvermelding. Sofie Cornelis Steffie Merckx

5 PREFACE Writing this master thesis after a four-year education in applied business economics feels like fitting the final piece of a giant puzzle. A lot of effort was necessary. However, looking back to the result gives much satisfaction in return. There are some people we would like to thank for their support. First, we owe many thanks to our promoter Prof. Dr. Philippe Van Cauwenberge for his time, guidance and critical reflections. Next, we are grateful to Katrien Kestens and Kelly De Brabanter for their assistance and useful advice. Furthermore, we thank our life partner and our family for giving us their moral support. May 2009, Sofie Cornelis Steffie Merckx The effect of notional interest deduction on the financing policy of SMEs I

6 TABLE OF CONTENTS PREFACE... I TABLE OF CONTENTS... II LIST OF ABBREVIATIONS... III LIST OF TABLES... IV LIST OF FIGURES... IV ABSTRACT Introduction The notional interest deduction Literature overview Allowances for corporate equity in practice Effects of notional interest deduction on the marginal tax rate Simulation of the marginal tax rate Effects of the marginal tax rate on debt policies Capital structure theories The irrelevance theorem Trade-off theory Pecking order theory Empirical analysis Sample Descriptive statistics Multivariate analysis General model Extension Conclusions REFERENCES... V APPENDIX... IX The effect of notional interest deduction on the financing policy of SMEs II

7 LIST OF ABBREVIATIONS ACE Adj. EBIT Excl. GDP Incl. MTR NACE-BEL NID OLO OLS POT PV SME Th. TLCF TOT VAT VIF Allowances for Corporate Equity Adjusted Earnings Before Interests and Taxes Exclusive Gross Domestic Product Inclusive Marginal Tax Rate Nomenclature générale des Activités économiques dans les Communautés Européennes - Belgique Notional Interest Deduction Obligation Linéaire Lineaire Obligatie Ordinary Least Squares Pecking Order Theory Present Value Small and Medium sized Enterprise Thousands Tax-Loss Carryforward Trade-Off Theory Value Added Tax Variance Inflation Factor The effect of notional interest deduction on the financing policy of SMEs III

8 LIST OF TABLES Table 1 : Example (1) of Graham s method without NID...8 Table 2 : Example (1) of Graham s method without NID (continued)...8 Table 3 : Example (1) of Graham s method with NID...9 Table 4 : Example (1) of Graham s method with NID (continued)...10 Table 5 : Example (2) of Graham s method without NID...11 Table 6 : Example (2) of Graham s method without NID (continued)...11 Table 7 : Example (2) of Graham s method with NID...12 Table 8 : Example (2) of Graham s method with NID (continued)...12 Table 9 : Descriptive statistics...24 Table 10 : Wilcoxon Signed Ranks Test (N=763)...27 Table 11 : Pearson correlation coefficients (N = 765)...28 Table 12 : Regression results: General model...32 Table 13 : Regression results: General model (continued)...36 Table 14 : Regression results: Extension...39 Appendix A : Definition of variables...ix Appendix B : Empirical predictions by the main theories and their outcomes concerning the determinants of capital structure in SME financing...x LIST OF FIGURES Figure 1 : Firm distribution by industries (N=1127)...26 Figure 2 : Evolution of the average proportion of capital structure components (N=763)...26 The effect of notional interest deduction on the financing policy of SMEs IV

9 ABSTRACT The principal aim of this paper is to test how the notional interest deduction affects the capital structure of Small and Medium sized Enterprises (SMEs). To assess any impact of notional interest deduction on the leverage of firms, we make use of simulated corporate marginal income tax rates. We carry out an empirical analysis of 1127 Belgian SMEs over the period , modelling the leverage ratio as a function of firm specific attributes hypothesized by capital structure theories. The results suggest that the marginal tax rate is positively related to leverage. The general conclusion in this study is that the notional interest deduction has a negative impact on the optimal level of debt in SMEs. Key words: Capital Structure, Financing, Small and Medium sized Enterprises, Notional Interest Deduction, Marginal Tax Rate. The effect of notional interest deduction on the financing policy of SMEs 1

10 1. Introduction Since January 1 st 2006, the Belgian tax regime incorporates notional interest deduction to eliminate the fiscal discrimination between debt versus equity financing. Previously, the corporate tax law allowed the deduction of interests from a companies taxable income, while this was not permitted for dividends. Although the Belgian notional interest deduction is merely an application of the more encompassing ACE-system, where ACE is known as Allowances for Corporate Equity, the existence of many variants together with the fact that few countries are willing to adopt the ACE approach makes the Belgian tax system unique in the world (Klemm, 2007). So far, no other academic studies have empirically examined the notional interest deduction. This paper is the first to investigate the impact of notional interest deduction on the capital structure of small and medium sized enterprises (SMEs). Whereas a lot of existing literature has examined the impact of tax incentives in a static legislative environment, we now have the opportunity to conduct research in a time period where tax legislation changes. Our study therefore complements the existing literature. To assess the existence and size of any impact of notional interest deduction on the leverage of firms, we make use of corporate marginal income tax rates. The simulation of these marginal tax rates is based on the approach developed by Shevlin (1990) and Graham (1996). We define the corporate marginal tax rate as the change in the present value of expected current and future tax liabilities caused by a one-time additional euro of interest cost today. As the deduction of a fictitious notional interest will decrease taxable income, the companies marginal tax rate will decrease. This means companies will experience less incentives to increase debt in order to shield profits from taxes. In this light, we expect the notional interest deduction to have a negative impact on leverage. We focus on SME financing because of two reasons. First, this type of company represents a large portion of all companies in Belgium. On January 1 st 2007, about 99,4% 1 of total companies were classified as SME. In addition, the percentage used to calculate the notional 1 Source: The effect of notional interest deduction on the financing policy of SMEs 2

11 interest is always 0,5 percentage points higher for companies defined as SME. Compared to large firms, this special treatment should make it even more favourable for smaller firms to finance with equity. The analyses in this paper are based on data from the Belfirst database provided by Bureau Van Dijk. We gather a sample of 1127 SMEs. The question that arises is whether or not the decrease in the marginal tax rate due to notional interest deduction is significant enough to find an appreciable impact on their optimal capital structure. We examine this relationship by means of an OLS regression. To isolate the individual effect of notional interest deduction, we control for profitability, investments, growth opportunities, tangibility, size and dividend payout. The time period covered in our study is 2005 until The remainder of this paper is organized as follows. Section 2 describes the features of notional interest deduction into more detail. Section 3 continues with an overview of literature. First, section 3.1 covers the more general tax system known as Allowances for Corporate Equity (ACE). Next, section 3.2 describes the effect of notional interest deduction on the marginal tax rate of a firm through some illustrative examples. Section 3.3 subsequently discusses the simulation of marginal tax rates as developed by Graham. We will further extend this model to include notional interest deduction into the calculation of taxable income. This is followed by the formulation of our hypothesis concerning the effect of the notional interest deduction on debt policies in section 3.4. In section 3.5 we briefly discuss the existing theories relating to capital structure together with previous findings in literature for small firms. Section 4 describes the sample selection, contains some descriptive statistics, explains the econometric methodology applied and presents the regression results. Finally, we conclude in section 5. The definition of variables together with an overview of the empirical predictions by the main theories and their outcomes concerning the explanatory variables in SME financing, are provided in the Appendix. The effect of notional interest deduction on the financing policy of SMEs 3

12 2. The notional interest deduction In accordance with article 205bis of the Income Tax Code, introduced by the law of June 22 nd 2005, companies submitted to the Belgian corporation tax can use a deduction for risk capital, also known as notional interest deduction. The goal of the notional interest deduction system is to encourage the strengthening of a companies equity by narrowing the fiscal discrimination between funding with equity and funding with debt, as currently, interests are tax deductible while dividends are not. There are two main advantages of notional interest deduction. First, when companies exploit the opportunity of free tax deduction by strengthening their equity, they will be better protected against failure. Second, the licences of coordination centres to enjoy substantial tax benefits would terminate since December 31 st The introduction of notional interest deduction was the only valuable alternative for the Belgian government to keep Belgium an attractive country for domestic and foreign investors. In addition to these main advantages, the notional interest deduction will be especially important for SMEs in particular. As these smaller firms are yearly responsible for more than 70% 3 of the Belgian GDP, it is quite important for the Belgian economy that these firms are in good health. The notional interest deduction system gives them the opportunity to substitute equity for debt in financing decisions. The law of June 22 nd 2005 came into operation on January 1 st It offers companies the opportunity to reduce their taxable basis with a deduction for risk capital. The amount of this deduction for a given year is calculated as a percentage of their adjusted equity at the end of the previous taxable period. Some corrections of the equity are needed to eliminate double counting and to avoid abuse of the system by artificially raising the equity. If the company s taxable income is not sufficient to completely utilize the notional interest deduction, the difference can be transferred to the next taxable period. However, in contrast to 2 Source: 3 Source: The effect of notional interest deduction on the financing policy of SMEs 4

13 normal losses that can be transferred without limitation, the unused amount of notional interest can be transferred for only seven years following the year of the initial deduction. For tax year 2008, the percentage used to calculate the notional interest deduction amounts to 3,78% 4. This figure changes every year. The interest rate is based on the average of monthly reference indices of Belgian OLO bonds on 10 years publicized during the year prior to the financial year to which the relevant tax year refers. For companies defined as SMEs according to article 15, 1 of the Code of Companies, the rate increases with 0,50%. In other words, SMEs can deduct 4,28% of their corrected equity at December 31, 2006 from their taxable income of This makes it even more favourable for smaller firms to finance with equity. In reality, there prevails however big confusion about the precise definition of SME that is applicable. While article 205quater of the Income Tax Code only refers to the quantitative criteria of article 15, 1 of the Code of Companies, there is no consistency in the law of June 22 nd 2005 about whether or not to use the time related criterion. Moreover, the Minister of Finance takes up another position. Going counter to article 205quater of the Income Tax Code, he explains that a company which is defined as an SME according to the quantitative criteria as well as the time related criterion of article 15, 1 of the Code of Companies, can take advantage of the higher percentage for notional interest deduction. This means when a company exceeds no more than one of the following quantitative criteria: 1) workforce of 50 employees on average, 2) turnover of 7,3 million (VAT excluded), 3) balance sheet total of 3,65 million, and when the workforce includes no more than 100 employees. These quantitative criteria have to be satisfied for two successive years prior to the financial year in which a company could be classified as an SME (time related criterion). The fiscal administration seems to follow the Minister of Finance s approach 5. 4 Source: 5 Source: 205quater-%C2%A7-6-en.aspx The effect of notional interest deduction on the financing policy of SMEs 5

14 3. Literature overview 3.1. Allowances for corporate equity in practice The Belgian notional interest deduction can be considered as an example of an ACE tax system, where ACE stands for allowances for corporate equity. In most corporate income tax systems, interest costs incurred due to the use of debt capital are deductible from the companies taxable income, while dividends are not. This results in an unequal tax treatment of the returns on debt and equity. The aim of an ACE is to tackle the discrimination against equity capital by allowing firms to deduct a notional return from their taxable income in addition to any interest expense from debt capital. This notional return is calculated as the firm s equity at the end of the previous year multiplied by a risk free nominal interest rate. However, ACE tax systems also have some drawbacks. As the allowance for corporate equity reduces a firm s taxable base, the government s revenues will decrease significantly in aggregate. Most likely, a higher tax rate will need to be imposed to finance this gap. In times of strong globalization, such a decision can cause the tax system to lose competitiveness. In addition, when dividends and interests are not equally taxed at the individual level, the socalled neutrality between equity and debt as a financing choice would not occur. In the past, other countries like Croatia in 1994, Italy in 1997 and Austria in 2000 have introduced ACE systems. By the year of 2004, they nevertheless withdrawed from using the system. Outside Europe, Brazil uses another variant of an ACE since Its corporate tax law only allows notional interest deduction to the extent that it is paid out to the shareholders. The existence of variants to the ACE tax system as described in literature combined with the fact that few countries are willing to adopt the ACE system makes the application of notional interest deduction in Belgium unique in the world. (Klemm, 2007) 3.2. Effects of notional interest deduction on the marginal tax rate It is widely recognized that tax implications are important for understanding a variety of corporate decisions, including the determination of capital structure. For example, firms with a high marginal tax rate are hypothesized to use more debt. The effect of notional interest deduction on the financing policy of SMEs 6

15 A corporation s marginal tax rate (MTR), as defined in Graham (1996a) is the present value of expected current and future taxes paid on an additional dollar of income earned today. In a later paper, Graham (2001) demonstrates that the present value of those extra taxes paid is equal to the present value of the tax benefit of an incremental dollar of interest deducted from this additional dollar of income. The approach to estimating corporate MTRs is originally developed by Shevlin (1990) and subsequently elaborated by Graham (1996a,b). A key insight is that the MTR depends essentially upon expectations of future taxable income. This means that the companies management is required to make forecasts of income before interest and taxes (EBIT) for future periods. Before we explain the simulation of these forecasts in section 3.3, we will first give two examples to demonstrate how to interpret the MTR in accordance with the second definition of Graham. After each example, we will describe how the MTR will change if we include notional interest deduction. We refer to today s time period as period 0, next year s period as period 1, etc. A practical issue is the determination of the length of the forecasting interval. On the one hand, the carryforward of tax losses is unlimited in time in Belgium. On the other hand, the carry-forward of an unused amount of notional interest from a given year is only permitted up to seven years. Therefore, we consider seven years after the year of consideration as a cut-off point. In the following two examples we assume a statutory tax rate of 33,99% and a company discount rate r d equal to 10%. The percentage r NID for the calculation of notional interest is 4,281% for SMEs in the financial year Suppose that the firm has an opportunity to undertake a valuable project. The first line of tables 1 to 8 shows us the predicted income for period 0 to 7 that the firm would enjoy if it invests in the project. In the first period presented in table 1, the firm will earn 100 of income, have 50 of interest deductions and a tax loss carry-forward (TLCF) of 10. This results in a taxable income of 40. Therefore, the firm will pay 13,60 of taxes (= 33,99% * 40) in period 0. In period 1, the firm earns an EBIT of 120, still deducts 50 of interests from debt but has no longer tax loss carry-forwards outstanding. The taxable income is 70, which results in a tax liability of 23,79. The same process continues for period 2 to 7. The present value of the tax liability in each period is calculated at a 10% discount rate r d. The sum of these expected current and discounted future tax liabilities from period 0 until period 7 is equal to 112,08. The effect of notional interest deduction on the financing policy of SMEs 7

16 Table 1 : Example (1) of Graham s method without NID period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: TLCFs from previous years Taxable income Taxes (@ 33,99%) 13,60 23,79 27,19 15,30 20,39 18,69 15,30 17,00 Earnings after taxes 26,40 46,21 52,81 29,70 39,61 36,31 29,70 33,01 PV tax liability 13,60 21,63 22,47 11,49 13,93 11,61 8,63 8,72 Sum of PV tax liabilities 112,08 The firm decides to finance the project with debt so that the interest cost increases once with 1 in period 0 (Table 2). As of period 1, the increase in debt will be undone. Consequently, the interest cost turns back to its former level of 50. The computations proceed just as before by determining the tax liability for each year. The present values are again calculated at a 10% discount rate. Only by paying one extra euro of interest, the present value of the expected current and future tax liabilities decreases to 111,74. To determine the MTR(excl. NID), we calculate the change in the sum of the present values of the tax liabilities from the incremental euro of interest deduction in period 0. By making the decision to finance with debt, the firm saves 0,3399 of tax payments (= 112,08 111,74), which is equal to the statutory tax rate t. Consequently, it increases the firm value by (t * 1). Table 2 : Example (1) of Graham s method without NID (continued) period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: TLCFs from previous years Taxable income Taxes (@ 33,99%) 13,26 23,79 27,19 15,30 20,39 18,69 15,30 17,00 Earnings after taxes 25,74 46,21 52,81 29,70 39,61 36,31 29,70 33,01 PV tax liability 13,26 21,63 22,47 11,49 13,93 11,61 8,63 8,72 Sum of PV tax liabilities 111,74 The next step in our analysis is to illustrate the effect of notional interest deduction (NID) on the MTR of a company. We apply the same story. Consider table 3, which includes NID in the calculation of earnings after taxes. This time we make the assumption that earnings after taxes are completely distributed as dividends and that the firm will not issue shares in the The effect of notional interest deduction on the financing policy of SMEs 8

17 eight year period. Accordingly, equity and the amount of NID will remain constant over the whole period. To determine the amount of notional interest, we assume an adjusted equity of 800 at the end of period -1. This figure multiplied by r NID (4,281%) gives us a notional interest of 34,25. Because of the notional interest deduction, the tax liability ( 1,95) in period 0 is lower than in the situation without NID in table 1. The same conclusion applies for period 1 to 7. The net present value of the expected current and future tax liabilities is now equal to 43,77. Table 3 : Example (1) of Graham s method with NID period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: notional interest deduction 34,25 34,25 34,25 34,25 34,25 34,25 34,25 34,25 Less: TLCFs from previous years Taxable income 5,75 35,75 45,75 10,75 25,75 20,75 10,75 15,75 Taxes (@33,99%) 1,95 12,15 15,55 3,65 8,75 7,05 3,65 5,35 Earnings after taxes 3,80 23,60 30,20 7,10 17,00 13,70 7,10 10,40 PV tax liability 1,95 11,05 12,85 2,75 5,98 4,38 2,06 2,75 Sum of PV tax liabilities 43,77 To assess the MTR(incl. NID), we assume that the firm decides again as in table 2 to finance the valuable project with debt so that the interest cost increases with 1 in period 0 (Table 4). However, in this case, we need to give some further explanations about the increase in debt that corresponds to the 1 increase in interest cost. For a constant balance sheet total, an increase in debt corresponds to a decrease in the level of equity and hence a proportional decrease in NID. If we assume that the interest cost on debt capital is equal to 4,85%, an increase of 1 of interest corresponds to an increase in debt and an identical decrease in equity of 20,62 (= 1/0,0485). This change will in turn lead to a decrease in NID of 0,88 (= 0,04281 * 20,62). The amount of NID becomes 33,37. For the periods 1 to 7, the interest and NID revert to former levels. The sum of the present values of the expected current and future tax liabilities is equal to 43,72. The net effect is a reduction from 43,77 to 43,73 caused by an extra euro of interest. The firm has a marginal tax benefit of 0,0408. In other words, MTR(incl. NID) is 4,08%. The effect of notional interest deduction on the financing policy of SMEs 9

18 The difference between MTR(excl. NID) and MTR(incl. NID) is equal to 29,91 percentage points (=33,99% - 4,08%). This means that, everything else remaining equal, the MTR of a firm decreases due to the incorporation of NID in the corporate tax system. More specifically, there are two partial effects of NID on the MTR. First, the deduction will decrease the taxable income. Second, an increase of 1 in interest costs corresponds to a decrease in equity which will decrease the amount of NID and thus increase the taxable income. The latter is only true under the assumption of a constant balance sheet total. Without this prudence measure, equity would not necessarily decrease after an increase in debt. Consequently, the NID would not automatically decrease and taxable income and tax liabilities would not increase subsequently. When the assumption of a constant balance sheet total does not go up, the effect of NID will be even bigger. Table 4 : Example (1) of Graham s method with NID (continued) period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: notional interest deduction 33,37 34,25 34,25 34,25 34,25 34,25 34,25 34,25 Less: TLCFs from previous years 10,00 0,00 0,00 0,00 0,00 0,00 0,00 0,00 Taxable income 5,63 35,75 45,75 10,75 25,75 20,75 10,75 15,75 Taxes (@ 33,99%) 1,91 12,15 15,55 3,65 8,75 7,05 3,65 5,35 Earnings after taxes 3,72 23,60 30,20 7,10 17,00 13,70 7,10 10,40 PV tax liability 1,91 11,05 12,85 2,75 5,98 4,38 2,06 2,75 Sum of PV tax liabilities 43,73 In the previous example, EBIT was always large enough to carry the amount of interest, notional interest and TLCFs from previous years. However, when this is not the case, it is necessary to take into account the carryforward tax treatment of notional interest and the carryback and carryforward tax treatment of net operating losses in the calculation of the MTR. In Graham s papers, a firm that experiences a net operating loss is allowed to carryback the loss and to receive a tax refund for taxes paid in the previous two years. Losses not carried back can be carried forward and are used to offset taxable income up to 20 years in the future. This regulation differs from the Belgian tax system, which does not apply the carryback of tax losses, but allows carryforwards for an unlimited time period. Tables 5 to 8 provide an illustration of how debt dynamics can complicate the calculation of marginal tax rates. The only adjustment that is made to the previous example in tables 1 to 4 is that EBIT The effect of notional interest deduction on the financing policy of SMEs 10

19 in period 0 is forecasted to be 60 instead of 100. When no notional interest is deducted (Tables 5 and 6), the change in the sum of the present values of the tax liabilities caused by an incremental euro of interest deduction in period 0 is equal to 0,3090, which is the MTR(excl. NID). Table 5 : Example (2) of Graham s method without NID period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: TLCFs from previous years Taxable income Taxes (@ 33,99%) 0,00 23,79 27,19 15,30 20,39 18,69 15,30 17,00 Earnings after taxes 0,00 46,21 52,81 29,70 39,61 36,31 29,70 33,01 PV tax liability 0,00 21,63 22,47 11,49 13,93 11,61 8,63 8,72 Sum of PV tax liabilities 98,49 Table 6 : Example (2) of Graham s method without NID (continued) period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: TLCFs from previous years Taxable income Taxes (@ 33,99%) 0,00 23,45 27,19 15,30 20,39 18,69 15,30 17,00 Earnings after taxes 0,00 45,55 52,81 29,70 39,61 36,31 29,70 33,01 PV tax liability 0,00 21,32 22,47 11,49 13,93 11,61 8,63 8,72 Sum of PV tax liabilities 98,18 However, when NID is applied (Tables 7 and 8), the firm has not enough EBIT to fully deduct the amount of notional interest which is equal to 34,25 (= 0,04281 * 800). After deducting the interest costs of 50 the firm has only 10 of earnings left in period 0. The firm can only subtract 10 of notional interest and carryforwards the remainder of 24,25 to period 1 in order to reduce taxable income in that period. The tax-loss carryforward of 10 is also transferred to future periods. Because the firm has no taxable income in period 0, the tax liability is zero. In period 1, the notional interest of period 1 as well as the carryforward of notional interest from period 0 can be absorbed completely (34, ,25 = 58,50). Even the tax losses from previous periods can be fully deducted. For periods 2 to 7, there is no change in the calculations. The sum of the present values of the expected current and future tax The effect of notional interest deduction on the financing policy of SMEs 11

20 liabilities is equal to 31,23. To calculate MTR(incl. NID), consider again in period 0 the onetime increase of 1 in interest costs and a one-time decrease of notional interest to 33,37. Further reasoning remains the same. As in the first example (tables 1-4), MTR(incl. NID) is again lower than the statutory tax rate. The marginal tax benefit of deducting an extra euro of interest in period 0 is 0,0371, when we apply NID, instead of 0,3090 in the situation without NID. In addition, MTR(incl. NID) and MTR(excl. NID) are both lower than in the first example. Next to the decrease in EBIT, the reason for this decrease in tax benefit is having not sufficient profit in period 0 to cover the amount of interests, notional interest and TLCFs completely in period 0. Consequently, tax deductions are realized in a later period. Considering the time value of money, no full tax benefits will be realized. Table 7 : Example (2) of Graham s method with NID period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: notional interest deduction 10,00 58,50 34,25 34,25 34,25 34,25 34,25 34,25 Less: TLCFs from previous years 0,00 10,00 0,00 0,00 0,00 0,00 0,00 0,00 Taxable income 0,00 1,50 45,75 10,75 25,75 20,75 10,75 15,75 Taxes 0,00 0,51 15,55 3,65 8,75 7,05 3,65 5,35 Earnings after taxes 0,00 0,99 30,20 7,10 17,00 13,70 7,10 10,40 PV tax liability 0,00 0,46 12,85 2,75 5,98 4,38 2,06 2,75 Sum of PV tax liabilities 31,23 Table 8 : Example (2) of Graham s method with NID (continued) period 0 period 1 period 2 period 3 period 4 period 5 period 6 period 7 EBIT Less: interest Less: notional interest deduction 9,00 58,62 34,25 34,25 34,25 34,25 34,25 34,25 Less: TLCFs from previous years 0,00 10,00 0,00 0,00 0,00 0,00 0,00 0,00 Taxable income 0,00 1,38 45,75 10,75 25,75 20,75 10,75 15,75 Taxes 0,00 0,47 15,55 3,65 8,75 7,05 3,65 5,35 Earnings after taxes 0,00 0,91 30,20 7,10 17,00 13,70 7,10 10,40 PV tax liability 0,00 0,43 12,85 2,75 5,98 4,38 2,06 2,75 Sum of PV tax liabilities 31,19 The effect of notional interest deduction on the financing policy of SMEs 12

21 3.3. Simulation of the marginal tax rate In this section, we describe the procedure we will use later on to simulate dynamic marginal tax rates for the companies in our sample. To account for the dynamic nature of the tax code in our simulation, we follow the approach originally developed by Shevlin (1990) and subsequently elaborated by Graham (1996a,b). We define the corporate marginal income tax rate as the change in the present value of current and expected future tax liabilities caused by a one-time additional euro of interest cost today. MTR 2004(i) is the MTR of firm i in the year 2005, determined with data available at the end of the year is the last year for which there was no NID. Similarly, MTR 2006(i) is the MTR of firm i in the year 2007, based on data at the end of Since 2006, NID is already applied. It is desirable to estimate the MTR by supplementing historical data with a stream of forecasted future taxable incomes and then to calculate the tax bill over the entire time horizon in a manner that is consistent with the tax rules. Tax-loss carrybacks allow the firm to carry losses retroactively back to receive a refund for taxes paid in the previous years. Taxloss carryforwards (TLCFs) indicate that a firm can carry forward any tax losses not carried back and use them to shield future profits from taxes. In Graham s approach, TLCFs are limited up to 20 years and tax-loss carrybacks are possible for a maximum of 2 years (Graham, 2001). However, the Belgian tax law does not allow to carryback any tax losses while TLCF are permitted unlimited in time. We limit the length of the forecasting period to eight years as notional interest may only be carried forward up to seven years. To forecast the stream of future taxable incomes at the end of year t-1, Graham s main model states that a firm i s earnings follow a pseudo-random walk with drift: EBIT it = μ i + ε it, where EBIT it is the first difference in earnings, μ i is the maximum of the mean of EBIT i and zero, and ε it is the deviation of EBIT it from its mean. ε it is normally distributed with mean zero and variance equal to that of EBIT i. The first step in simulating the MTR consequently consists of calculating the mean and variance of the change in earnings before interest, TLCFs, and taxes (EBIT) at time t-1. The effect of notional interest deduction on the financing policy of SMEs 13

22 Unlike literature (Graham 1996a, 1996b, 2008), where the calculation of mean and variance of the change in EBIT for a given firm is based on historical data until year t, we use data from the firm s industry in year t-1. The second step forecasts EBIT for year t and beyond. Using the mean and variance calculated in step one, we forecast the change in earnings for each firm 8 years into the future. Adding these changes to EBIT t-1 will result in a time series of forecasted EBITs (from year t to year t+7). After the deduction of interests and any TLCFs, the third step then calculates the current and future tax liabilities on the taxable income of each time period. The computation of these tax liabilities are based on a progressive tax rate. Next, we calculate the present value of the tax liabilities by discounting to year t, using the average interest rate of year t-1 (for example: 4,73% in 2006). The fourth step adds a one-time additional euro of interest cost today and recalculates the present value of expected current and future tax liabilities. The decline in tax liability, in comparison with the third step, is the present value tax advantage from having an extra euro interest cost today. Such a simulation provides one estimate of the MTR, for a single firmyear. The procedure just described is repeated 50 times to obtain 50 estimates of the MTR in year t, with each simulation based on a new forecast of 8 years of EBIT. The mean of the 50 estimates of the marginal tax rate is the expected MTR of firm i in year t, a single expected marginal tax rate for a single firm-year. We replicate the steps for each firm and each year that is included in our empirical analysis. The marginal tax rates vary across firms and can also vary through time for a given firm. This method can be applied to calculate MTR 2004(i), which is the marginal tax rate for the last year in which there was no NID. However, to calculate MTR 2006(i), we have to extend Grahams method to a model that takes the notional interest deduction into account. First, we assume that realized profits after taxes are held within the company. In other words, we assume that firms do not distribute profit after taxes as dividends. This is a reasonable assumption as at least 80% of the SMEs in our sample (infra, p. 25) does not pay dividends. The consequence is that equity increases when a firm is profitable. The extended model should therefore deal with the increase in equity to continue its calculations of the NID. The effect of notional interest deduction on the financing policy of SMEs 14

23 The first and second step of Grahams method remain the same. The third step differs when NID is taken into account. To calculate taxable income, en thus the tax liability, we first have to determine the amount of notional interest that will be deducted from EBIT after interest expenses but before TLCFs. In each forecasted period, this amount will be a percentage on the amount of equity at the end of the previous period, while equity increases each period with the after tax profit. The fourth step calculates the MTR by adding 1 extra interest cost in the first period, next to accounting for the NID. However, an increase in interest costs implies a change in the level of debt. For a given balance sheet total, the increase in debt corresponds in a decrease in the proportion of equity. This lower equity base leads to a decrease in NID and a higher tax liability than in the third step of this model. Therefore, the model has to take into account these considerations when NID is applied. Next, the MTR is calculated by taking the difference of the sum of the present values of the tax liabilities calculated in the third and fourth step. This is one single estimate of MTR it. A total of 50 simulations are performed for each firm in the sample for each year in the time series. We then take the average of the 50 simulated MTRs, which will represent the expected marginal tax rate of firm i in year t Effects of the marginal tax rate on debt policies Financial theory is clear that the marginal tax rate is relevant when analyzing optimal debt levels and incremental financing choices. Literature (MacKie-Mason, 1990; Graham, 1996a) documents a positive relationship between tax rates and the use of debt as a financing instrument. In other words, firms with a high marginal tax rate have a greater incentive to issue debt compared to a low-mtr firm, because of the higher tax advantage from interest deductibility. This implies a positive relationship between a firm s MTR and its ultimate debt level. In this paper, our primary focus is the effect of the NID on the optimal level of debt. Since the notional interest is an extra (fictitious) deduction on EBIT, it reduces a firm s taxable income. Therefore, after the introduction of notional interest, the MTR will be lower. This effect is illustrated in the examples discussed in section 3.2. Consequently, because of the positive relationship between the MTR and debt, firms will aim at a lower proportion of debt in their capital structure when they apply NID. The effect of notional interest deduction on the financing policy of SMEs 15

24 We translate this in the following hypothesis: Notional interest deduction has a negative influence on leverage (H1). While the focus of this paper is to investigate whether leverage decisions are affected by the change in MTR (= MTR NID - MTR NO NID ), it is important to control for competing explanations of the debt policy. These control variables are discussed in the next section Capital structure theories A lot of theory has been written in literature about the existence of an optimal capital structure that maximizes the value of a company The irrelevance theorem The debate starts with the irrelevance theorem of Modigliani and Miller (1958). These two economists state that in a so-called perfect world debt-equity choices and debt maturity choices are irrelevant. In other words, capital structure decisions cannot affect the value of the firm. There would not be an optimal capital structure. The value of a firm is only equal to the present value of all future operating cash flows which depend on the profitability of its assets and future investment opportunities. Capital structure decisions would only change the distribution of cash flows to the providers of funds but do not affect their availability. Modigliani and Miller (M&M) argued that investors can finance a part of their portfolio of shares with debt equally well when an organization is not willing to do so. The capital structure of a company is therefore not of value to investors. Moreover, when two companies with the same operational performance are traded at different prices because of a different capital structure, arbitrage will dissolve the price difference. The theorem of M&M is only true under a lot of explicit and implicit assumptions, mainly: 1) no corporate nor personal taxation, 2) perfect capital markets, containing no information asymmetry, no transaction costs and no institutional restrictions, 5) no bankruptcy costs, 6) homogeneous expectations about the total return of a company and 7) firms can be assigned to a risk class which includes firms with the same operational risk. The effect of notional interest deduction on the financing policy of SMEs 16

25 However, none of the assumptions really applies in reality. In an attempt to explain why the way of financing a company does seem to matter, a large amount of research has relaxed quite a number of these assumptions Trade-off theory According to the static trade-off theory (TOT) the capital structure of a firm moves towards an optimal debt ratio as companies weigh up the corporate tax savings advantage of debt and the costs of financial distress. The corporate tax law allows interest payments to be deducted from the taxable income of the firm while deduction of dividend payments is not permitted. The trade-off theory states that firms will prefer debt to other financing resources due to this fiscal approach. The tax advantage of debt will increase the value of the firm as it increases its after-tax cash flow. If there were only a corporate profits tax and no individual taxes on the returns from corporate securities, the value of a debt-financed company would equal that of an identical all-equity firm plus the present value of its interest tax shields (Barclay & Smith, 2005, p.9) or V with debt = V without debt + PV interest tax shields with: PV interest tax shields = (MTR x I D x D) / I D = MTR x D where V stands for the market value of the company, PV interest tax shields for the present value of the interest tax shields, MTR means marginal tax rate, I D represents the cost of debt capital and D the principal amount of outstanding debt. The formulation assumes that the firm will maintain its current debt level in the future and that there will always be enough earnings to deduct the interests from. The trade-off theory predicts that firms with high profitability should have higher debt ratios, because they use debt as a means of reducing their tax payments. Higher profits allow the firm more corporate tax deductions. Some authors like López-Gracia and Sogorb-Mira (2008) have pointed out that this fiscal approach cannot be applied in the small firm context. SMEs are less likely to be profitable and are therefore less likely to use debt in order to get tax shields The effect of notional interest deduction on the financing policy of SMEs 17

26 because they will not need them. Following this line of reasoning there should not exist a relationship between debt and taxes in SMEs. A second element the theory takes into account to determine the optimal capital structure of a firm is the cost of financial distress. Financial distress arises when the perceived probability that the firm will default is greater than zero. The stakeholders of the company are uncertain about the expected future cash flows and each will start to bring its own interests to safety, based on specific and incomplete information. Consequently, the threat of bankruptcy is already sufficient to cause direct and indirect costs. Direct costs of bankruptcy are deadweight costs peculiar to the bankruptcy process while indirect costs of bankruptcy are related to lost opportunities. Since debt implies fixed interest and capital repayments, a rising debt ratio increases the risk of facing liquidity problems. The trade-off theory argues when the costs of financial distress are relatively high the optimal debt ratio will be relatively low. From the same point of view, we can accept there is a positive relationship between firm size and debt. Size is often used in research as an inverse proxy for the probability of default. Larger firms are likely to be more diversified which reduces their earnings volatility and thus their operating risk. Besides they mostly have a better reputation on the capital markets as a result of which they can ask for a higher amount of debt financing. All this reduces financial distress and will allow a higher debt ratio. Empirical research by López-Gracia and Sogorb- Mira (2008), Sogorb-Mira (2005), Cassar and Holmes (2003), Michaelas, Chittenden and Poutziouris (1999), Chittenden, Hall and Hutchinson (1996a) and Van der Wijst and Thurik (1993) confirms this prediction. Besides the costs of financial distress, agency costs are often included in the balancing process. The agency theory investigates the conflict of interests between various financial stakeholders of the firm, which occur in SMEs especially between shareholders and debtholders. We could expect these agency problems to be higher in smaller firms as a small business owner/manager is more likely to put his own interest first. The occurrence of information asymmetries adds to these problems. Furthermore, the alternatives to solve agency problems are relatively more expensive for small businesses. Monitoring will be difficult and expensive because they are allowed to disclose less information than big firms. Incentive systems and debt covenants will also be difficult to implement. These costs can be avoided by offering a collateral to banks (Stiglitz & Weiss, 1981). It is assumed that firms, The effect of notional interest deduction on the financing policy of SMEs 18

27 which possess tangible assets with a high collateral value, will have easier access to external funds and therefore have a high level of debt in their capital structure. The existing research does not find consisting evidence though. Some authors found positive relationships with debt as well as with long-term debt and short-term debt (Michaelas et al., 1999), some authors acquired positive relationships with debt and long-term debt while a negative relationship with short-term debt (Sogorb-Mira, 2005; Chittenden et al., 1996a; Van de Wijst & Thurik, 1993), and others obtained a negative relationship with debt because the negative relationship with short-term debt dominated the positive relationship with long-term debt (Cassar & Holmes, 2003). In accordance with Myers (1977) the underinvestment problem - forgo investment projects with a positive net present value - caused by potential costs of financial distress will become more intense in companies with high growth opportunities. Creditors will reduce their supply of funds to this type of firms as they fear bigger information asymmetries. Myers states one of the possible solutions could be the issuance of short-term debt instead of long-term debt. In line with this proposition, long-term debt should have a negative relationship with growth opportunities while short-term debt should be positively affected by growth opportunities. As SMEs mainly rely on short-term debt financing, authors like Sogorb-Mira (2005), Michaelas et al. (1999) and Chittenden et al. (1996a) have found a positive relationship between debt and growth opportunities, which is in contrast to Myers first assertion. On the other hand, companies having extensive free cash flow operating cash flow that cannot be reinvested profitably can face to an overinvestment problem when they use it to sustain growth. After all, investing in projects with a negative net present value will undermine profitability. In order to maximize its value, such a company should distribute its free cash flow. Accordingly the agency theory predicts a negative relationship between a companies leverage and dividend payout, as they are seen as two main and substitutable alternatives for cash flow distribution. In addition, when comparing companies that generate similar amounts of cash flow, it is obvious that companies with more profitable investments will be less levered. Therefore, the agency theory also predicts a negative relationship between the level of investments and leverage (Fama & French, 2002). Yet, there is little evidence for these predictions in the literature. The effect of notional interest deduction on the financing policy of SMEs 19

28 Pecking order theory In contrast with the static trade-off theory, the pecking order theory (POT) denies the existence of an optimal capital structure. According to Myers and Majluf (1984), the actual capital structure of a company is rather achieved by accident. It is the result of some pecking order behaviour. In their attempt to maximize value, companies will always choose the cheapest way of financing. For that reason, managers will prefer internally generated funds as a primary source. Only when internal financing isn t sufficient, they will resort to external sources. In that case, managers will again choose the cheapest financing method. They will prefer debt to equity and short-term debt to long-term debt. This pecking order behaviour would be caused by the presence of information asymmetries between the firm and potential external financiers. In other words, it is believed that insiders have more private information about the firm than outside investors. Consequently, to protect themselves against the risk of overestimating of the value of issued debt or equity, new funds providers will demand a higher rate of return on their invested capital. This rate of return, which is a financing cost for the company, will relatively vary between different financing choices. Equity holders will expect a higher risk premium than debt holders, because they are the residual owners of the company and therefore experience a greater risk than the latter. After our literature research, we found several reasons to believe that information asymmetries are much bigger for SMEs than for large firms. First, the quality of the reported financial statements of Belgian SMEs turns out to vary a lot (Pettit & Singer, 1985). Some SMEs report according to the complete format, while a lot of other SMEs report according to the abbreviated format in which they are allowed to disclose less information. In addition, the costs to take care of audited financial statements seem to be too high for SMEs. Second, SME owners are usually also manager of the firm. Consequently, they will not make financing choices in which they lose property and control over their company (Hamilton & Fox, 1998; Holmes & Kent, 1991). After the use of retained earnings, they would first appeal to funds supplied by current shareholders of the firm before going to external sources of finance (Ang, 1991). Moreover, owner-managers of small firms are more likely to take risks than managers in large firms (Pettit & Singer, 1985). Finally, most SME securities are not publicly traded. The effect of notional interest deduction on the financing policy of SMEs 20