An allowance for costs of corporate equity financing has been proposed in the United Kingdom as a means of eliminating the distortions created by the debt-equity distinction in the corporate tax context. See Institute for Fiscal Studies, Tax By Design: The Mirrlees Review.This proposal comes after a comprehensive review of the British tax system (the "Mirrlees Review") by a prominent group of international tax experts. The study identified traits of a desirable modern tax system and assessed the U.K.'s tax system to determine the extent to which it conforms to these principles. Belgium enacted a similar allowance in 2005 which has substantially enhanced the efficiency of its corporate tax system.
Like the British tax system, the U.S. tax system encourages debt financing by permitting tax deductions for interest paid but not for dividends paid. A tax deduction for costs of equity financing would deincentivize extensive corporate leveraging and neutralize debt-to-equity ratios. In essence, tax considerations would be eliminated (as they should be) from the decision of whether to employ debt or equity financing. As a result, corporations would become more efficiently structured from a capital perspective and resources which are currently being allocated to tax planning could be reallocated to more value-added activities.
For instance, under current U.S. tax law, the determination of whether an instrument should be treated as debt or equity involves a balancing test, which is quite costly in terms of both time and money, to determine whether the instrument is more like debt or equity. See I.R.C. § 385(b). Under this balancing test, the following factors are considered:
- Whether there is a written unconditional promise to pay, on demand or on a fixed date, a sum certain in money in return for an adequate consideration, and to pay a fixed rate of interest;
- Whether there is subordination to or preference over any corporate indebtedness;
- The ratio of debt to equity;
- Whether there is convertibility into common stock; and
- The relationship between the holdings of stock in the corp and the holdings of the interest in question